New Option Study Reveals Telling Data

10/10/2011 11:15 am EST

Focus: OPTIONS

A recent scientific study proved that a particular option strategy was more profitable than simply buying the index, even in highly volatile or unfavorable market conditions.

The University of Massachusetts recently released a study on covered calls that examines returns on a buy-write strategy for the Russell 2000 index over a 15-year period. It is quite thorough and scientific. Highlights of the report include:

"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."

"Over the 182-month period of analysis, the RUT buy-write strategy using 2% out-of-the-money, one-month calls generated higher returns than the underlying index (8.87% versus 8.11%) at about three-quarters of the standard deviation (16.57% versus 21.06%)."

"One of the worst market conditions for the buy-write strategy is March 2003 to October 2007, when the Russell 2000 experiences a high sustained growth at a relatively low volatility. Even in this market environment, we find that the 2% out-of-the-money, one-month buy-write strategy outperforms the Russell 2000 on a risk adjusted basis, returning almost the same returns as the index return at three-quarters its volatility."

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"It is evident that if we disregard transaction costs, the cumulative growth of the ATM buy-write strategy over the 15 years of our study far surpasses that of the Russell 2000, with less volatility."

Kapadia and Szado’s final conclusion on the covered call return offered by the strategy of writing 2% OTM calls on the Russell 2000 index:

"Overall, our results suggest that the buy-write strategy can outperform the index under standard performance measures. This risk adjusted outperformance also holds during the unfavorable market conditions of March 2003 to October 2007, where the Russell 2000 was steadily trending upwards. The outperformance is largely limited to writing one-month calls while the strategy of writing two-month calls typically underperforms both the one-month strategy and the index." - 5 Years of The Russell 2000 Buy-Write, by Nikunj Kapadia and Edward Szado (Sept. 15, 2011)

Option trading works folks—and can produce “alpha” if you are patient and disciplined.

By Mike Scanlin of Born To Sell

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