Abstract: Using data from January 18, 1996 to November 16, 2006, we construct and evaluate returns on a buy-write strategy on the Russell 2000 index. The results demonstrate that the strategy has consistently outperformed the Russell 2000 index on a risk adjusted basis, when implemented with one month to expiration calls and when performance is evaluated using standard performance measures. The out-performance is robust to measures which specifically consider the non-normal distribution of the strategy’s returns. However, the consistent performance advantage does not remain if we utilize two month to expiration calls.
To evaluate the performance in varying market conditions, we break our sample into sub-periods. Specifically, one of the worst market conditions for the buy-write strategy is February 2003 to November 2006, when the Russell 2000 experiences a high sustained growth at a relatively low volatility. Even in this market environment, we find that the buy-write strategy outperforms the Russell 2000 on a risk adjusted basis, returning two-thirds of the index return at half its volatility.
We provide insight into the sources of the performance. On average, written calls end up in-the-money and transaction costs of writing the call at the bid further increases the losses. However, the buy-write strategy benefits by writing calls at an implied volatility higher than the realized volatility. In fact, we find that the contribution of the volatility risk premium – the difference between implied and realized volatility – is typically larger than the net losses incurred by the call position or the transaction costs. It appears that the existence of the risk premium is critical to the performance of the strategy. In fact, the (Leland’s) alpha of the strategy is typically significantly smaller than the risk premium, implying that the buy-write strategy would not provide excess returns in the absence of the risk premium.