Buy-write strategies on the Russell 2000 index yield better risk-adjusted performance than the index itself, according to a study by the Isenberg School of Management's Center for International Securities and Derivatives Markets at the University of Massachusetts, Amherst. Professor Nikunj Kapadia and doctoral student Edward Szado, looking at data from Jan. 18, 1996, to Nov. 16, 2006, concluded that a passive buy-write strategy of one month to expiration calls on the Russell 2000 universe consistently outperformed the index on a risk-adjusted basis. (A buy-write strategy involves buying stocks and writing covered-call options on them to maximize return derived from option premiums and dividends.)
The Russell 2000 averaged an annualized return of 10.67% over the period studied, similar to the out-of-the-money buy-write strategy on the index (when the option strike price is higher than the stock price). The return was 9.21% with at-the-money buy-writes (when the option strike price is equal to the stock price), but the strategy resulted in 13.3% volatility, much lower than the average 20.5% volatility for the Russell 2000. For the out-of-the-money strategy on the Russell 2000, volatility was 14.8%.
The authors of the study pointed out that the selection criteria for the calls are important in determining the strategy's returns because transaction costs and the volatility risk premium have a significant impact on returns.
"Even when used conservatively, options can provide a unique source of alpha with impressive risk-reduction benefits," they wrote.
The Options Industry Council, a non-profit industry group, commissioned the survey to better inform institutional investors about options.