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Ia a buy-write for you? - Eureka Report article

Is a buy-write for you?

By Scott Francis
December 23, 2010

PORTFOLIO POINT: The strategy promises extra income and reduced volatility, but I’m not convinced.

The world of options can be intimidating to many investors and with good reason. But there is one strategy that could be of genuine interest to Eureka Report readers that I’d like to discuss called the buy-write or covered call strategy.

Before we get into the specifics – and we will return to them shortly – the strategy involves selling a call option over shares that you own to generate extra income for your portfolio.

The basic idea is that you generate income by selling the call option, which also helps smooth your overall investment returns over time.

The ASX has created an index to help you track the performance of such a strategy over the benchmark helpfully named the S&P/ASX Buy-Write Strategy (XBW).

Whether you choose to refer to the technique as buy-write or covered call doesn’t really matter. What does matter is that the strategy has achieved a degree of popularity in the United States and much like our article from a previous edition about leveraged ETFs (click here), it’s probably only a matter of time before products based on this idea hit our shores.

In Australia, there are already managed funds that provide a similar investment opportunity. The big selling points are that a buy-write investment helps smooth volatility, adds income to a portfolio and provides investors with another source of diversification.

What I want to do today is start by looking at how it works, back-test the strategy, consider the limitations of the research and look at some existing buy-write investments on the market today.

It is worth noting that entire books are written on the strategy – so today’s article can only provide a starting point investors who are seriously considering the strategy.

What is a buy-write strategy?

It’s a combination of a share investment and an option. The option used is a call option, which gives the owner the right to buy a share or index at a price up to a date in the future.

For example, if you buy a call option for Telstra shares at $2.80 for the end of December 2010, it gives you the right to buy Telstra shares at $2.80 up to the end of December.

If Telstra shares are trading above this price, say $2.90, you will exercise your right to buy those Telstra shares at $2.80 because you can immediately sell those shares at $2.90 and make a profit. Conversely, if the Telstra shares are trading at $2.70 you will not exercise your option to buy the shares at $2.80 because you can simply buy them on the market at $2.70 – 10¢ per share cheaper.

The next step is how the call option and the share investment fit together.

Let's say that you own 10,000 Telstra shares and they are trading at $2.75. You are able to sell a call option for 10,000 Telstra shares at $2.80 within three months for 8¢ a share. This provides you with income of $800.

If the Telstra shares remain below $2.80 then nothing will happen to the shares, and you will have generated an extra $800 (the income from selling the call options).

If, in three months’ time, Telstra shares are trading at more than $2.80, the owner of the call option will exercise their right to buy the shares. In this case you will have lost any price gain on the shares beyond $2.80 – locking in the price of $2.80 – while earning an extra $800 of income.

As you can see from this example, when markets trade sideways or down the covered call strategy provides greater earnings because you receive the income from selling the call option, without any change to the underlying portfolio. However, when the shares you own go up sharply in value your returns can decrease, as you will have to sell your shares to the option owner, losing some of the upside.

Is it an effective strategy?

Proponents of a buy-write strategy make two important claims:
  • The strategy is less volatile that a straight sharemarket investment.
  • It works well in a falling or flat sharemarket.
The evidence on a buy-write strategy used with an index investment seems to be mixed. Some researchers support it. For example, in 2005 the Journal of Investing published the paper entitled Passive Option-Based Investment Strategies: The Case of the CBOE S&P 500 Buy-Write Index.

I know what you are thinking: Did they come up with a must read title for their paper or what?

Anyway, they compared the returns from the S&P 500 to an S&P 500 buy-write strategy for the 16 years between 1988 and 2004. They found that he buy-write strategy had an average annual return of 12.39% compared to the simple index return of 12.2%.

They also found that the buy-write strategy has less volatility.

Other researchers reported similar results – including Kapadia and Szado (2007) in their paper, The Risk and Return Characteristics on the Russell 2000 Index.

That said, other researchers in our own back yard have found the opposite result – with an Australian paper from RMIT entitled The Efficiency of the Buy-Write Strategy: Evidence from Australia' based on Australian data from 1995 to 2006 – finding that:

“Even when controlling for financial fundamentals, we could not isolate evidence that a buy-write strategy consistently outperforms equity portfolios. Consequently, we are not convinced of the superiority of the buy-write strategy for individual stocks traded on the Australian market. Investors appear to be better off with a pure equity portfolio in many instances.”

A concern with the research that I have read into many trading strategies and buy-write in particular is that they have not addressed the issue of tax. There is no question that there will be significant tax and trading costs with this strategy and many others like it. Every time a call option is sold, income is generated that can be taxed. If an investor sells shares because the call option they have sold is exercised, then potentially they have to pay tax. The buying and selling of call options and shares create transaction costs just like brokerage.

Buy-write strategies in Australia

A reasonably long standing example of a buy-write strategy in Australia is the Macquarie Australian Equities Income Fund. It uses a buy-write strategy to provide the “potential for more income” and “lower risk” than the ASX 200 index.

The fund has a minimum investment of $20,000 and an MER of 1.25% per annum. It was started in March 2004. It describes its operation as thus:

“The Fund operates using a ‘buy write’ strategy. This strategy involves investing in a portfolio of Australian shares while simultaneously selling options aiming to generate additional income”

The returns from the fund make interesting reading. Since March 2004 the fund has provided average annual income of 12.68% a year. This is about three times the income of the ASX 200 Accumulation Index. These high levels of income are likely to lead to high levels of tax for taxable investors, which are perfectly understandable for a strategy that makes that income by selling call options.

From its inception in March 2004 to the end of September 2010, the Macquarie fund using the buy-write strategy has had a return of 4.8% a year compared to the average market return of 9.13% a year. And importantly, the volatility of the buy-write strategy was lower than the volatility of the ASX 200 index.

Overall these are hardly compelling figures. The Macquarie Australian Equities Income Fund did outperform the average market return over the three years to the end of September 2010, returning –5.37% a year compared to the ASX 200 market return of –7.01%; however, it underperformed over every other timeframe reported from its inception.

Great concept but …

The buy-write strategy should be of interest to investors – with claims of higher levels of income, potential outperformance in down markets and lower volatility all sounding attractive. Any strategy with such a detailed amount of supporters and detractors is usually worth looking into, if only for the sake of curiosity. However for real-world investors the consideration of tax does not seem to be taken into account.

While the Macquarie Australian Equities Income Fund outperformed the benchmark over the three years to the end of September 2010 and provided investors with lower volatility by using this strategy, its performance over other timeframes has been less than compelling.

At the heart of the matter for an investor is this question: If I want to reduce the volatility of my share portfolio by about one-third (which is the reduction reported by the Macquarie Fund and the S&P 500 study), will I get a better after-tax return from investing in a buy-write style investment, or will I get a better return from investing one-third of my money in cash (which will reduce portfolio volatility, and provide better returns than a simple share investment in a falling market) and the rest in a simple share investment.

My thinking is that the jury is still out: a buy-write strategy provides something to consider but I will need some more convincing evidence before pursuing it in my portfolio.