Characteristics of the Buy-Write Strategy on the Russell 2000 Index

Characteristics of the Buy-Write Strategy on the Russell 2000 Index

Using data from January 18, 1996 to November 16, 2006 , a study by Kapadia and Szado demonstrated that a passive buy-write strategy of one month to expiration calls on the Russell 2000 Index consistently outperformed the Russell 2000 Index on a risk adjusted basis. Over the 10 year study period, the Russell 2000 index had an annualized return of 10.67% while the 2% out-of-the money (?OTM?) buy-write strategy on the Russell returned an almost identical annualized 10.60% and an at-the-money (?ATM?) buy-write returned an annualized 9.21%.

These buy-write returns were produced with a significant reduction of annualized volatility. The ATM buy-write strategy yielded a 1/3 lower annualized volatility of 13.36% compared to 20.52% for the Russell 2000 and 14.85% for the OTM strategy (see summary statistics). To evaluate the performance in varying market conditions, the study developed sub-period analysis.  Specifically, one of the worst market conditions for the buy-write strategy was February 2003 to November 2006, when the Russell experienced a high sustained growth at a relatively low volatility.  Even in this market environment, the study found that the buy-write strategy easily outperformed the Russell 2000 by standard measures, returning two-thirds of the index return at half its volatility.

Meanwhile in the sub-period up to February 2003, the OTM and ATM buy-write strategy outperformed the Russell 2000 on an absolute basis by returning an annualized 6.19% and 5.06% respectively vs. a 3.84% return for the index but with only 2/3 of the Russell volatility.

Conclusion

The study examined the returns on buy-write strategies on the Russell 2000 over the period 1996-2006. Overall, the results suggest that the buy-write strategy can outperform the index. The out performance was largely limited to writing 1-month calls while the strategy of writing 2-month calls typically underperformed both the 1-month strategy and the index.  It is clearly evident that the method of execution of the strategy as well as transaction costs and the choice of the options has a large impact on the performance of the strategy. Results indicate that if the option was written at the theoretical Black Scholes price associated with the realized volatility, the buy-write strategy would under perform the index over the sample period. In this light, the study provided only a conservative analysis of the buy-write strategy?s performance, since the implementation does not allow for an active selection of the time to expiration of the calls. There is some evidence in the literature that a more active approach to call selection can result in significantly higher absolute and risk adjusted returns.