the performance of options-based investment strategies: evidence for individual stocks during...

Copyright © 2015 Michael L. Hemler and Thomas W. Miller, Jr.

1

The Performance of Options-Based Investment Strategies: Evidence for Individual Stocks During 2003─2013

Michael L. HemlerUniversity of Notre Dame

Thomas W. Miller, Jr.Mississippi State University

U N I V E R S I T Y O F

NOTRE DAME

OIC Financial Advisors ForumHotel Fontainebleau

Miami Beach, FL

May 8, 2015


2

Prologue: What Motivated This Study?

• In Spring 2013 Alan Grigoletto of the Options Industry Council (OIC) contacted Mike Hemler regarding a potential options research project.

• Alan noted that large pension funds used options to alter the risk-return profile of their investment portfolios, e.g., the Ontario Teachers’ Pension Plan and the New Jersey Public Employees’ Pension Plan

• Alan also noted that existing studies on the performance of option strategies typically focused on covered calls or collars using index (mostly S&P 500) options.

• Alan suggested that large institutional investors would welcome a study that compared the performance of the standard “buy and hold” strategy versus option strategies that include long equity. They would be especially interested in a study that focused on individual stocks, rather than equity indexes.

• See the CBOE website http://www.cboe.com/micro/buywrite/ for references on options-based strategies and benchmark indexes. In addition, see the CBOE March 2015 Risk Management Conference: http://www.cboe.com/rmc/2015/Day-1-Session-2-Speth.pdf and http://www.cboe.com/rmc/2015/Day-1-Session-2-Black-Szado-projector.pdf.

http://www.cboe.com/micro/buywrite/

http://www.cboe.com/micro/buywrite/

http://www.cboe.com/rmc/2015/Day-1-Session-2-Speth.pdf

http://www.cboe.com/rmc/2015/Day-1-Session-2-Speth.pdf

http://www.cboe.com/rmc/2015/Day-1-Session-2-Black-Szado-projector.pdf

http://www.cboe.com/rmc/2015/Day-1-Session-2-Black-Szado-projector.pdf


3

Introduction• Options are a convenient and effective tool for portfolio

managers who want to tailor equity positions, augment income, or limit risk in changing market conditions.

• A popular strategy is the covered call (or, buy-write) strategy: it combines a long equity position with a short call position.– Whaley (2002) examines the CBOE Buy-Write Index (BXM) during 1988-2001,

and concludes that “BXM outperformed the S&P 500 portfolio by approximately 0.2% a month on a risk-adjusted basis.”

– Hill, Balasubramanian, Gregory, and Tierens (2006) analyze various S&P 500-overwriting strategies, concluding that such strategies “have very favorable performance characteristics at a range of risk levels.”

– Kapadia and Szado (2007) examine the buy-write strategy on Russell 2000, concluding “the buy-write strategy can outperform the index.”


4

Introduction• Another popular strategy is the collar: it combines a long equity

position, a short call position, and a long put position.

• A collar is simply a covered call that adds a long put position.– The option parts are sometimes known as “split-strike” conversions.– One can form a “zero-cost” collar, and combined it with long equity.– The resulting payoff profile resembles a vertical bull spread.

• Collar studies include:– Szado and Schneeweis (2010) analyze collars based on the PowerShares QQQ

exchange-traded fund. With their method, they conclude that collars gave superior returns and reduced risk compared to the buy-and-hold strategy.

– Szado and Schneeweis (2012) analyze collars across a range of asset classes, including equity, currency, commodity, real estate, and fixed income. They conclude that “for most of the asset classes considered, an options-based collar strategy … provides improved risk-adjusted performance and significant risk reduction.”


5

Introduction

• In this study, we investigate the performance of options-based strategies.

• Our analysis differs in two major respects:– We compare the relative performance of four (not one)

options-based strategies versus the corresponding long equity strategy.

– We focus on individual stocks, not indexes (e.g., S&P 500).• S&P 500 options are European; they cannot be exercised early. • Options on individual stocks are American; they can be exercised early. • This early exercise feature complicates the analysis if:

– There are dividends and the option strategy involves a short call position.– The option strategy involves short put positions.


6

Payoff Diagrams for Strategies We Investigate(Note: We shall not be holding strategies until expiration.)

Long Stock, Long Put

Long Stock, Long Put, Short Call

Long Stock, Short Put, Short Call

Covered Call:

Protective Put:

Collar:

Covered Combination:

Long Stock, Short Call


7

What Do We Do and What Do We Find?• What Do We Do?

– We examine the relative performance of four option strategies and long equity using ten stocks commonly used in 401(k)s.

– We examine performance during 2003-2013, both over the entire period and the first and second halves.

– We use four popular performance measures (Sharpe ratio, Jensen’s alpha, Treynor ratio, and Sortino ratio).

– For simplicity we ignore early exercise and transaction costs.

• What Do We Find?– In general, the covered combination and covered call strategies outperform the long

stock strategy– In general, the long stock strategy outperforms the collar and protective put strategies.– Our findings are preliminary because we do not have definitive answers to:

• What is the impact of early exercise?• What is the effect of transaction costs?• To what extent does the Leland (1999) critique alter the interpretation of CAPM-based

performance measures?


8

The Stocks in The Study• We wanted a small, representative sample that might especially interest large

institutional investors who typically “buy and hold” stocks.

• We also wanted a “third party” to choose the stocks in order to avoid any accusation of “cherry picking” firms for our sample.

• We use a list of ten stocks given in the CNBC story of September 12, 2012, entitled “Widely Held Stocks in 401(k)s.”

– See http://www.cnbc.com/id/48939384/page/1.

• CNBC asked Morningstar to compile a list of the top ten firms in 401(k)s.

• In decreasing order: ExxonMobil, Comcast, Berkshire Hathaway (Class A), Oracle, Microsoft, Coca-Cola, Amazon, Wells Fargo, Google, and Apple.

– There are no exchange-traded options on Berkshire Hathaway (Class A), but there are such options on Berkshire Hathaway (Class B).

– Rather than drop Berkshire Hathaway, we substitute Class B for Class A.

http://www.cnbc.com/id/48939384/page/1

http://www.cnbc.com/id/48939384/page/1


9

Sample Period and Data Sources

• Our sample period runs from January, 2003 through August, 2013, which is the last month for which we have options data.

– There are 50 observations for Berkshire Hathaway, 108 observations for Google, and 128 for all other stocks due to different dates for introduction of option trading.

• For convenience, in our sample:– We call 2002-2007 the first half. – We call 2008-2013 the second half.

• Our stock and T-bill data are from the Center for Research in Security Prices (CRSP). – Stock returns are value-weighted returns including distributions. – T-bill returns are based on a thirty-day target maturity.

• Options data are from OptionMetrics, with the exception of early exercise data from the Options Clearing Corporation (OCC).

• Options returns are based on bid-ask midpoints.


10

How Do We Implement the Option Strategies?• We choose options that are at least 5% out of the money, but with strike

prices as close as possible to the opening stock price on the day strategy is initiated.

• We focus on monthly returns. – We roll over positions monthly on the last business day. – When we choose options for a given month, we pick options expiring the next month. – For instance, to calculate the return for a covered call during January, 2003, we choose

the call traded throughout January which expires in February, 2003.

January Trading Days With Feb.

Expiration

February Trading Days With Mar.

Expiration

(1)

(2)


11

Empirical Results• We compute monthly returns for the four option strategies and the long

equity strategy for each of the ten stocks.

• In general, we find that compared to the long equity strategy:

– The covered call yields: lower standard deviations of return and (often) higher mean returns.

– The protective put yields: lower standard deviations of return and lower mean returns.

– The collar yields: lower standard deviations of return and lower mean returns.

– The covered combination yields: higher standard deviations of return and higher mean returns.

– Returns for all options strategies exhibit extreme non-normality, either skewness or kurtosis or both. This fact raises major issues when interpreting standard performance measures such as Jensen’s alpha.


12

Comparing Mean Returns and Standard Deviations of Returns Between Each Option Strategy and Long Equity

• For each stock and option strategy, calculate the differential between:– the mean return of the option strategy and the mean return of the long equity

strategy.– the standard deviation of returns from the option strategy and the standard

deviation of returns from the long equity strategy.

• For each option strategy, average the differentials across all ten stocks.

• The results cluster in four groups, one for each of the strategies. – The covered combination tends to have the highest mean and standard

deviation. – The collar tends to have the lowest mean and standard deviation.


13

Exhibit 1Average Differential Means and Standard Deviations of Returns Between Four Option Strategies and the Corresponding

Long Equity Strategy for Ten Stocks (January, 2003 – August, 2013)


14

Performance Measures

• Exhibit 1 provides information regarding risk and return, but it does not explicitly address the issue of whether the risk-return tradeoff is favorable.

• To investigate performance, we utilize four popular measures:– Sharpe ratio– Jensen’s alpha– Treynor ratio– Sortino ratio

• We compute these four measures for each of the five strategies and ten stocks. – For each stock we rank the five strategies from 1 to 5 in terms of decreasing

performance.– We then average the rankings across all ten stocks. Exhibit 2 presents the results.


15

Exhibit 2Average Rankings of the Relative Performance of Four Option Strategies

and the Corresponding Long Equity Strategy for Ten Stocks(January, 2003 – August, 2013)


16

Empirical Results• The results of Exhibit 2 are striking in their consistency.• The same general theme holds for the entire period 2003-2013

and both sub-periods 2003-2007 and 2008-2013. • From best to worst, the strategies rank as follows:

– Covered combination– Covered call– Long equity– Collar– Protective put

• Although the consistency of these results is persuasive, there are complicating issues (which we shall address) that prevent these results from being as compelling as one might believe at first glance.


17

How Do Cumulative Returns Compare Across These Five Strategies?

• Does one get the same relative rankings using cumulative returns as one gets with the aforementioned performance measures?

• Exhibit 3 displays the cumulative return results for all five strategies and ten stocks over 2003-2013.

• The covered combination dominates by ranking first for all stocks except Google.

• The covered call beats long equity for all stocks except Apple, Amazon, and Google.

• Overall, the average rankings presented in Exhibit 3 agree with the average rankings summarized in Exhibit 2.


18

Exhibit 3Rankings of Performance of Cumulative Returns from Five Strategies for Ten Stocks

(January, 2003 – August, 2013)

Covered Protective LongTICKER OBS Call Put Collar Combo Stock

AAPL 128 3 4 5 1 2AMZN 128 3 4 5 1 2BRK 50 2 5 4 1 3CMCSA 128 2 5 4 1 3GOOG 108 4 3 5 2 1KO 128 2 5 4 1 3MSFT 128 2 5 4 1 3ORCL 128 2 5 4 1 3WFC 128 2 4 5 1 3XOM 128 2 5 4 1 3

Average: 2.4 4.5 4.4 1.1 2.6

Strategy Ranking, by Ticker


19

Cumulative Return on a $1 Investment in AAPL

Note the Y-Axis


20


21


22

First Complicating Issue:Transaction Costs

• Consider the covered combination strategy.

• It involves two options positions, and those option positions are rolled over monthly.

• Including transaction costs (i.e., bid-ask spreads) will reduce, or possibly even eliminate, the apparent advantage that the covered combination has over the (already held) long equity position.


23

Second Complicating Issue: Non-Normality of Returns

• Leland (1999) explores this issue in detail, using a simple example to examine both the covered call and protective put strategies.

• Leland demonstrates that using CAPM-based performance measures where there are nonsymmetrical returns will:

– Overrate “rebalancing” strategies (which reduce or “sell” skewness), i.e., covered call– Underrate “momentum” strategies (which increase or “buy” skewness), i.e., protective put.

• His demonstration foreshadows our findings exactly! That is, he predicts: – The covered call strategy will outperform long equity.– The protective put strategy will underperform long equity.

• Note: Leland’s (1999) examples consider only strategies buying or selling options on the market, but similar results are likely for options on individual securities.


24

Second Complicating Issue: Non-Normality of Returns, Cont.

• Leland warns: “Any investment manager can ‘game’ the CAPM performance measurement by selling options or rebalancing.”

• Leland proposes a performance measure that is robust to non-normality of returns.

• Our preliminary investigations suggest that using Leland’s proposed measure does not change the relative rankings of the strategies.


25

Third Complicating Issue: Early Exercise

• Had returns been adjusted for early exercise:– Strategies involving (only) selling options, like the covered combination and covered call,

would obtain lower returns. – Strategies involving (only) buying options, like the protective put, would obtain higher

returns.

• Consequently:– The covered combination and covered call strategies might perform worse than they

currently appear to perform (based on Exhibit 2)– The protective put strategy might perform better than it currently appears to perform (based

on Exhibit 2)– The collar strategy might perform better or worse given that it involves both buying and

selling options.

• NOTE: Portfolio managers can, if they wish, avoid early exercise by:– Using stocks that do not pay dividends (short call strategies) – Using European-style FLEX options (short option strategies).


26

Early Exercise

• The OCC and Professor Robert Whaley gave us access to OCC data on early exercise used in Barraclough and Whaley (2012)


27

“Costs of Competition Send Amazon Profit Down 58%”http://www.nytimes.com/2006/07/26/technology/26amazon.html?_r=0

DateOption Volume

Option Open

Interest

Option Contracts Exercised

Implied Volatility

of the Option

Delta of the Option

Strike, X

AMZN Closing

Ask Price, S_Ask

Option Bid-Ask Midpoint

Put Price Lower

Bound: X - S_ask

BidAsk Midpoint

Minus Lower Bound

7/3/2006 146 6,700 0 0.4615 -0.2366 35 38.57 0.95 -3.57 4.527/5/2006 1,562 6,855 0 0.4573 -0.3148 35 37.09 1.30 -2.09 3.397/6/2006 494 8,049 0 0.4511 -0.3318 35 36.79 1.35 -1.79 3.147/7/2006 1,007 8,201 0 0.4572 -0.3781 35 36.10 1.60 -1.10 2.70

… … … … … … … … … … …

… … … … … … … … … … …

7/24/2006 4,499 15,073 0 0.6095 -0.5115 35 34.31 2.50 0.69 1.817/25/2006 6,877 17,027 0 0.6323 -0.5629 35 33.58 2.93 1.42 1.517/26/2006 65,554 20,482 62,720 35 26.18 8.75 8.82 -0.077/27/2006 43,326 11,693 45,722 35 26.53 8.45 8.47 -0.027/28/2006 8,039 6,914 8,150 35 27.17 7.80 7.83 -0.037/31/2006 53 6,759 1,387 0.6938 -0.9575 35 26.86 8.15 8.14 0.01

8/1/2006 39,855 6,622 40,860 0.8118 -0.9443 35 26.30 8.75 8.70 0.058/2/2006 6,004 3,653 6,164 35 26.09 8.90 8.91 -0.018/3/2006 3 3,493 0 35 26.64 8.35 8.36 -0.018/4/2006 12 3,496 7 35 27.26 7.70 7.74 -0.048/7/2006 0 3,487 4 35 26.79 8.20 8.21 -0.018/8/2006 6,968 3,483 7,571 35 26.35 8.60 8.65 -0.058/9/2006 5,808 2,880 5,804 35 26.22 8.80 8.78 0.02

8/10/2006 0 2,884 0 35 26.47 8.55 8.53 0.028/11/2006 2 2,884 1 35 26.02 9.00 8.98 0.028/14/2006 10 2,883 7 35 26.54 8.40 8.46 -0.068/15/2006 401 2,876 299 35 27.75 7.25 7.25 0.008/16/2006 0 2,565 1 35 27.92 7.10 7.08 0.028/17/2006 60 2,576 0 35 29.16 5.90 5.84 0.068/18/2006 25 2,581 0 35 29.11 5.90 5.89 0.018/19/2006 2,581


28

Summary of Our Results to this Point

•Long equity generally outperforms the collar and protective put.•The covered call generally outperforms long equity.•The covered combination generally outperforms long equity.

‒ Premature to conclude covered combination outperforms long equity in practice. ‒ The apparently superior performance could reflect the absence of:

‒ An early exercise adjustment‒ transaction costs

‒ There is also the Leland (1999) critique involving nonsymmetrical returns.

• Further analysis, however, should enable us to provide stronger evidence on the relative rankings of these options-based strategies versus long equity.


29

Where Do We Go From Here?

• We could:– Increase the number of stocks and lengthen the time period.– Estimate and incorporate transaction costs.– Estimate Leland’s (1999) performance measure

• OR alternatives such as Modigliani and Modigliani (1997), Stutzer (2000)• OR the “manipulation-proof” measure of Ingersoll et al. (2007).

– Adjust returns for early exercise.

• The biggest concern for us all remains:

What is the best way to measure the performance of options-based strategies?!


30

Questions and Comments?

the performance of options-based investment strategies: evidence for individual stocks during...

Documents

long equity position

performance of options

optionsbased strategies

introduction options

equity indexes

popular strategy

cboe buy

based investment strategies