Worry about more reversals in the stock market like the nearly 100-point drop in early in February hasn't caused many institutional investors to flock to using options hedging strategies to protect their equity portfolios against a downturn.
At Oppenheimer Capital, New York, Eugene D. Brody, managing director, said, "I haven't noticed any pickup of interest."
"Every time the market falters for a quarter, we look for a pickup of interest" in call options overwriting, said William O. Melvin Jr., executive vice president, Acorn Derivatives Management Corp., White Plains, N.Y. "But that hasn't happened."
"Many pension sponsors have been concerned about the valuation level in the market for some time, but they haven't altered their asset allocation because the market continues to do well," he added.
Both firms run a traditional call options overwriting overlay, along with another less-defensive options strategy.
"The strategy has been unpopular" for a number of years, Mr. Melvin added.
"I think it will take an extended down period - at least a year of a poor market - before people want to use a defensive strategy, which is what call overwriting is."
"This has been a bad market to sell covered calls," added Gregory M. McMurran, senior vice president, Analytic Investment Management Inc., Irvine, Calif., which offers a traditional options overwriting overlay, along with other options-based strategies.
But at Performance Analytics Inc., a Chicago-based consulting firm, Robert P. Moseson, president, suggests, "It makes a lot of sense to consider options overwriting at this point.
"The time to look at options overwriting is when the market is euphoric. If you are too early, you might give up some upside (in the market), but at this point there doesn't seem to be much upside left. There are too many signs the market is peaking."
According to Garrett Jones, principal, FX 500 Inc., Crystal Bay, Nev. - which runs only a derivative-based equity strategy of trading Standard & Poor's 500 futures contracts - "the market is very overvalued on a historical level, based on the three most basic fundamental valuation levels" - price-earnings ratio, price-to-book value ratio and dividend yield.
As of Dec. 31, according to Mr. Jones, the S&P 500's p/e ratio was 23, slightly below its all-time peak of 251/2 in 1992.
The price-to-book ratio was 3.9 times, the highest ever. At its peak in 1987, just before the October market crash, it was 2.9 times, he noted.
The dividend yield was 21/2% as of Dec. 31. "I believe this is the lowest in history. In 1987, it was 2.7%.
"These are fairly dramatic numbers," Mr. Jones added.
"We are approaching 40 months without as little as a 10% correction in the market," he said. "There have been only three other times in this century where we have gone as long as that without about a 10% correction: 1926 to 1929, which was followed by the biggest percentage decline (89% as measured by the Dow Jones industrial average) in the market; 1963 to 1966, which was followed by the longest bear market, from 1966 until 1982; and 1984 to 1987, which was followed by the largest point decline the market (more than 1,100 as measured Dow Jones industrial average) in history.
"It would be a major historic surprise if we didn't have a major correction. The risk is rampant.
"We thought the market was going to top last year. We were wrong. Our feeling is that at the very least we expect a substantial correction this year of 10% to 20%. (The market) flat-out looks dangerous to us."
Still, Oppenheimer's Mr. Brody added, "It's been a tough time for overwriters in a period of three years without a correction."
One of the biggest call overwriters until recently, Balch Hardy Scheinman & Winston Inc., New York, had lost most of its clients and overlay assets under management well before it was forced into bankruptcy in January after losing a lawsuit in a licensing dispute over the use of an options model.
"Business wasn't good," said R. Steven Hardy, principal, who oversaw marketing.
"Performance hasn't been good" for traditional options overwriting in general, he added. None of the major overwriting firms - with the exception of Loomis Sayles & Co., which uses a different, less-defensive strategy - has performed well, he added.
"Most managers who use it lost money in it," agreed Acorn's Mr. Melvin.
Loomis Sayles' Washington office, run by William Mullen, managing partner, manages for pension fund clients some $7 billion in call options overwriting, overlaid on equity portfolios managed by other firms.
Unlike traditional option overwriters, who are hedging equity portfolios, Loomis Sayles employs a different strategy to seek incremental return, rather than risk reduction.
"In a bull market, our option overwriting will perform better" than traditional overwriting, Mr. Mullen said. "In a down market, they will beat us."
The traditional options overwriting strategy involves writing, or selling, stock-index call options at the money, meaning where the option strike price is at or near the current market price of the underlying stock index. Overwriters try to profit by earning the premium from selling call options, on either individual stocks or stock indexes, assuming the options will expire worthless, if the market stays flat or falls. Typically, they hope to add 100 to 150 basis points onto the return of the underlying equities.
But when the market rises, overwriters face real or opportunity losses as buyers of calls seek to exercise them.
"If the market moves up, you don't receive enough in the option premium to compensate you for the risk of the stock price rising" and the gain forgone, said Analytic's Mr. McMurran.
Executives at the major firms, including Acorn, Oppenheimer, and Analytic - although each offers other, non-traditional overwriting strategies that have done fairly well - acknowledge their traditional overwriting strategy hasn't performed well in a rising market.
"It's been a terrible strategy for the last 10 years, because it's been a strong market," said Mr. Hardy.
Acorn's Mr. Melvin added, call option overwriting "has not been a good strategy for us in a rising market."
The firm manages an overlay strategy for pension funds on $700 million of underlying equities, managed by other firms. It sells calls on the options based on S&P 100 and S&P 500 stock indexes, hoping to earn the option premium without disturbing the value of the underlying equity portfolios.
But what has happened "when you write a call, the market goes up faster (or more) than the premium" earned on the option, he said. "So you lose money. It's an opportunity loss. You lose money on the strategy.
"Fewer people are doing it because, on a stand-alone basis, it has been a money-losing strategy. If you look at our performance for the last five years (Acorn began operating in 1988), it's been flat."
But he said, "If the market flattens out or declines, then the strategy would be profitable."
"Intrinsically, people are willing to give up upside in exchange for getting a cushion on the downside. But people have been saying, 'what am I giving up upside for when there's not going to be a down market?'*"
The strategy, he added, "is a lot less popular then it used to be."
Oppenheimer's Mr. Brody said, "With the market going up for three years, people have become very complacent, and since overwriters aren't making money for them, they aren't as interested" in the strategy now.
Oppenheimer, which manages overwriting programs on some $3 billion of underlying equities, managed by other firms, has performed "below average" in its traditional call overwriting over the last three years, he added.
Analytic's Mr. McMurran said, "There isn't much interest in covered calls because clients aren't interested in risk reduction."
The firm manages traditional overwriting on $150 million of underlying equities, while it has some $1.3 billion in other options-based strategies.
