Best Returns With Slightly OTM Options

While overwriting with near-dated expiries is clearly superior to overwriting with far-dated expiries, the optimal choice of strike to overwrite with depends on the market environment. As equities are expected, on average, to post a positive return, overwriting should be done with slightly OTM options.

However, if a period of time where equities had a negative return is chosen for a back-test, then a strike below 100% could show the highest return.Looking at a period of time where the SX5E had a positive return shows that for one-month options a strike between 103%-104% is best (see Figure 10 above).

Typically call overwriting with c25% delta call options is best

For three-month options, the optimal strike is a higher 107%-108%, but the outperformance is approximately half as good as for one-month options. These optimal strikes for overwriting could be seen to be arguably high, as recently there have been instances of severe declines (TMT bubble bursting, Lehman bankruptcy), which were followed by significant price rises afterwards.

For single-stock call overwriting, these strikes could seem to be low, as single stocks are more volatile. For this reason, many investors use the current level of volatility to determine the strike or choose a fixed delta option (eg, 25%).

OVERWRITING REDUCES VOLATILITY

While selling an option could be considered risky, the volatility of returns from overwriting a long equity position is reduced by overwriting. This is because the payout profile is capped for equity prices above the strike.

An alternative way of looking at this is that the delta of the portfolio is reduced from 100% (solely invested in equity) to 100% less the delta of the call (c50% depending on strike). The reduced delta suppresses the volatility of the portfolio.

Risk reduction less impressive if Sortino ratios are used
We note that the low call overwriting volatility is due to the lack of volatility to the upside, as call overwriting has the same downside risk as a long position.

For this reason, using the Sortino ratio (for more details, see the section A11 Sortino Ratio in the Appendix) is likely to be a fairer measure of call overwriting risk than standard deviation, as standard deviation is not a good measure of risk for skewed distributions.

Sortino ratios show that the call overwriting downside risk is identical to a long position; hence, call overwriting should primarily be done to enhance returns and is not a viable strategy for risk reduction.

Optimal strike is similar for single stocks and indices

While this analysis is focused on the SX5E, the analysis can be used to guide single-stock call overwriting (although the strike could be adjusted higher by the single-stock implied divided by SX5E implied).

ENHANCED CALL OVERWRITING IS DIFFICULT

Enhanced call overwriting is the term given when call overwriting is only done
opportunistically or the parameters (strike or expiry) are varied according to market
conditions.

On the index level, the returns from call overwriting are so high that enhanced call overwriting is difficult, as the opportunity cost from not always overwriting is too high.

For single stocks, the returns for call overwriting are less impressive; hence, enhanced call overwriting could be more successful. An example of single-stock enhanced call overwriting is to only overwrite when an implied is high compared to peers in the same sector.

We note that even with enhanced single-stock call overwriting, the wider bid-offer cost and smaller implied volatility premium to realised means returns can be lower than call overwriting at the index level.

Enhanced call overwriting returns likely to be arbitraged away

Should a systematic way to enhance call overwriting be viable, this method could be applied to volatility trading without needing an existing long position in the underlying.

Given the presence of statistical arbitrage funds and high frequency traders, we believe it is unlikely that a simple automated enhanced call overwriting strategy on equity or volatility markets is likely to outperform vanilla call overwriting on an ongoing basis.

PROTECTION STRATEGIES USING OPTIONS

For both economic and regulatory reasons, one of the most popular uses of options is to provide protection against a long position in the underlying. The cost of buying protection through a put is lowest in calm, low-volatility markets, but in more turbulent markets the cost can be too high.

In order to reduce the cost of buying protection in volatile markets (which is often when protection is in most demand), many investors sell an OTM put and/or an OTM call to lower the cost of the long put protection bought.

CHEAPEN PROTECTION BY SELLING OTM PUT & CALL

Buying a put against a long position gives complete and total protection for underlying moves below the strike (as the investor can simply put the long position back for the strike price following severe declines).

The disadvantage of a put is the relatively high cost, as an investor is typically unwilling to pay more than 1%-2% for protection (as the cost of protection usually has to be made up through alpha to avoid underperforming if markets do not decline).

The cost of the long put protection can be cheapened by selling an OTM put
(turning the long put into a long put spread), by selling an OTM call (turning put protection into a collar), or both (resulting in a put spread vs call, or put spread collar). The strikes of the OTM puts and calls sold can be chosen to be in line with technical supports or resistance levels.

Figure 11.:

* Puts give complete protection without capping performance. As puts give such good protection, their cost is usually prohibitive unless the strike is low. For this reason, put protection is normally bought for strikes around 90%. Given that this protection will not kick in until there is a decline of 10% or more, puts offer the most cost-effective protection only during a severe crash (or if very short-term protection is required).

* Put spreads only give partial protection but are cost effective. While puts give complete protection, often only partial protection is necessary, in which case selling an OTM put against the long put (a put spread) can be an attractive protection strategy. The value of the put sold can be used to either cheapen the protection or lift the strike of the long put.

* Collars can be zero cost as they give up some upside. While investors appreciate the need for protection, the cost needs to be funded through reduced performance (or less alpha) or by giving up some upside. Selling an OTM call to fund a put (a collar) results in a cap on performance. However, if the strike of the call is set at a reasonable level, the capped return could still be attractive.

The strike of the OTM call is often chosen to give the collar a zero cost. Collars can be a visually attractive low (or zero) cost method of protection as returns can be floored at the largest tolerable loss and capped at the target return. A collar is unique among protection strategies in not having significant volatility exposure, as its profile is similar to a short position in the underlying. Collars are, however, exposed to skew.

* Put spread collars best when volatility is high, as two OTM options are sold. Selling both an OTM put and OTM call against a long put (a put spread collar) is typically attractive when volatility is high, as this lifts the value of the two OTM options sold more than the long put bought. If equity markets are range bound, a put spread collar can also be an attractive form of protection. Put spread collars are normally structured to be near zero cost (just like a collar).

Figure 12.:

Portfolio protection is usually done via indices to lower cost

While an equity investor will typically purchase individual stocks, if protection is bought then this is usually done at the index level. This is because the risk the investor wishes to hedge against is the general equity or macroeconomic risk.

If a stock is seen as having excessive downside risk, it is usually sold rather than a put bought against it. An additional reason why index protection is more common than single stock protection is the fact that bid-offer spreads for single stocks are wider than for an index.

Figure 13.Option Strategy for Different Market and Volatility Views:

Partial protection can give attractive risk reward profile

For six-month maturity options, the cost of a 90% put is typically in line with a 95%-85% put spread (except during periods of high volatility, when the cost of a put is usually more expensive).

Put spreads often have an attractive risk-reward profile for protection of the same cost, as the strike of the long put can be higher than the long put of a put spread. Additionally, if an investor is concerned with outperforming peers, then a c10% outperformance given by a 95%-85% put spread should be sufficient to attract investors (there is little incremental competitive advantage in a greater outperformance).

Implied volatility is far more important than skew for put-spread pricing

A rule of thumb is that the value of the OTM put sold should be approximately one-third the value of the long put (if it were significantly less, the cost saving in moving from a put to a put spread would not compensate for giving up complete protection).

While selling an OTM put against a near-ATM put does benefit from selling skew (as the implied volatility of the OTM put sold is higher than the volatility of the near ATM long put bought), the effect of skew on put spread pricing is not normally that significant (far more significant is the level of implied volatility).

Collars are more sensitive to skew than implied volatility

Selling a call against a long put suffers from buying skew. The effect of skew is greater for a collar than for a put spread, as skew affects both legs of the structure the same way (whereas the effect of skew on the long and short put of a put spread partly cancels).

If skew was flat, the cost of a collar typically reduces by 1% of spot. The level of volatility for near-zero cost collars is not normally significant, as the long volatility of the put cancels the short volatility of the call.

Capping performance should only be used when a long rally is unlikely

A collar or put spread collar caps the performance of the portfolio at the strike of the OTM call sold. They should only therefore be used when the likelihood of a strong, long-lasting rally (or significant bounce) is perceived to be relatively small.

Bullish investors could sell two puts against long put

If an investor is bullish on the equity market, then a protection strategy that caps performance is unsuitable. Additionally, as the likelihood of substantial declines is seen to be small, the cost of protection via a put or put spread is too high. In this scenario, a zero cost 1×2 put spread could be used as a pseudo-protection strategy.

The long put is normally ATM, which means the portfolio is 100% protected against falls up to the lower strike, and gives partial protection below that until the breakeven. A loss is only suffered if the equity market falls below the breakeven.

1×2 put spreads only give pseudo-protection

We do not consider 1x2 put spreads to offer true protection, as during severe declines it will suffer a loss when the underlying portfolio is also heavily loss making. The payout of 1×2 put spreads for maturities of around three months or more is initially similar to a short put, so we consider it to be a bullish strategy.

However, for the SX5E a roughly six-month zerocost 1×2 put spread, whose upper strike is 95%, has historically had a breakeven below 80% and declines of more than 20% in six months are very rare. As 1×2 put spreads do not provide protection when you need it most, they could be seen as a separate long position rather than a protection strategy.

Figure 14.: