Buy-Write or Put-Write: An Active Index Writing Portfolio to Strike it Right

Abstract

Can simple technical analysis add value to index option selling investment strategies? To test this, I propose a dynamic allocation approach to construct option writing portfolios. Unlike the standard passive Buy-Write (covered call) and Collateralized Put-Write strategies, an active leveraged option overlay portfolio (ALOOP) involve switching between shorting call and writing put index options – a market timing scheme based on a technical rule.

In particular, I use S&P 500 Total Return Index as the underlying equity index and choose a simple but well known double moving average cross rule – Golden Cross/Black Cross as the trading signal. The portfolio is expressed analytically with two parameters controlling the level of portfolio leverage for an expected bullish or bearish market regime, respectively. In a back-test with 22.6 years (from 06/01/1988 to 12/31/2010) of daily close data, I consider different levels of estimated transaction costs for monthly portfolio rebalance, index option contracts roll-over or settlement, and active trading. An example case of the active portfolio achieves better returns and risk-adjusted returns than the CBOE S&P 500 Monthly Buy-Write (BXM) or Put-Write (PUT) Index, and out-performs the underlying equity index by over 5% in annualized return with similar levels of risk.

I further introduce a model based estimation of the active portfolio’s Greek Letter Delta. It is shown as the basis of an effective trading rule to improve portfolio performance by managing market risk weekly. Other special cases demonstrate that the dynamic overlay of written index options can be used as an alpha generating tool for cash management and passive equity index investments. A return attribution of the active investment portfolio identifies an active alpha from the Golden Cross/Black Cross market timing, a volatility skew risk premium, and their positive interactions. Potential market impacts of the active index writing strategies are also discussed.

Keywords: Buy-Write, Put-Write, Dynamic Asset Allocation, Technical Analysis, Index Option Overlay, Portfolio Leverage, Golden Cross and Black Cross, Volatility Skew, Active Alpha, Risk Management