The Benefits of Index Option-Based Strategies for Institutional Portfolios

Abstract

A cademic and practitioner research shows that many strategies that include index options have the potential to improve the riskadjusted return of equity portfolios (Rendleman [1999]; Beighley [1994]; Sorensen, Miller, and Cox [1998]). In particular, strategies that incorporate writing options have performed well over time. While the investment objectives of option-based strategies may differ, there are only a few potential explanations for the excess returns generated by many strategies. First, the investment managers may have unique skills in stock selection or market timing and may simply be using options as a vehicle to extract those returns. Second, managers may have unique skill in predicting changes in implied volatility, which would allow them to extract returns from other investors who lack this skill. Skill-based arguments may in fact explain the performance of a select group of managers, but since not all managers can have unique skills, investors would need to be able to identify which managers have these skills in order to earn positive returns from option-based strategies.Another possible source of return to certain index option-based strategies is that there may be a systematic bias in option premiums that benefits the seller of options over time. This bias may have its roots in behavioral finance-option buyers may consistently overestimate the expected volatility of stocks and stock indexes. The bias may also be explained in an asset-pricing context. If changes in implied volatility are correlated with the direction of the market, then equity options have a different level of systematic risk than the underlying. This would imply a source of return for options that is not available simply by trading the underlying stock or index.The empirical results presented in this study are based on the replication of passive index option-based strategies using daily data collected over the past 13 years. These passive benchmarks are then compared to the performance of a number of active managers. The results indicate that many passive investment strategies offered risk-adjusted returns that exceeded the underlying index over the time period studied. Furthermore, the returns to these passive option-based strategies provided useful benchmarks for the performance of the active managers studied. Results presented here demonstrate that the source of this additional return can be identified and explained by combining a passive stock index investment with a passively managed option portfolio. This is important because it demonstrates that the returns achieved by actively managed strategies are not necessarily dependent on the unique skills of the managers.

Return and Risk of CBOE Buy Write Monthly Index

“…One possible explanation, suggested by Stux and Fanelli [1990], Schneeweis and Spurgin [2001], and others, is that the volatilities implied by option prices are too high relative to realized volatility. Bollen and Whaley [2002] argue that there is excess buying pressure on S&P 500 index puts by portfolio insurers.…”

Optimal allocation to hedge funds: an empirical analysis

“…A possible remedy has been suggested to try and capture such non-linear dependence is to include new regressors with non-linear exposure to standard asset classes to proxy dynamic trading strategies in a linear regression. 14 Natural candidates for new regressors are buy-and-hold positions in derivatives (Schneeweis and Spurgin (2000), Agarwal and Naik (2001) or Fung and Hsieh (2001)), or hedge fund indices (Lhabitant (2001)). Here, we follow the latter 14 Alternatively, one may allow for a non-linear analysis of standard asset classes.…”

The Cash-secured PutWrite Strategy and Performance of Related Benchmark Indexes

“…[1990], Schneeweis and Spurgin [2001], Whaley [2002], Feldman and Roy [2004], and Hill et al [2006]). See Exhibit 15 for a graph with a comparison of S&P 500 options' implied volatility and the subsequent realized volatility for the S&P 500 Index.…”