What if there was an options strategy that took just 1 hour per month to implement while outperforming the S&P 500 in both return and reduced portfolio volatility? What if the same strategy was available to any trader, regardless of your account type or size?
Options trading strategies unlock exactly these sorts of possibilities. The prudent and cautious use of option contracts allows traders to earn returns over and above those provided by standard market benchmarks. They can protect traders from unexpected volatility in the market while improving their access to outsized returns.
You work hard for your money, and it doesn't take a high level of sophistication or degree in finance to generate higher returns with less risk. You can accomplish these goals without a significant time commitment by following the strategies outlined below
30-Delta BuyWrite Index Strategy Overview
The 30-Delta BuyWrite Index options trading strategy involves just a few simple steps:
- Buy a stock.
- Sell a covered call option against that stock.
- Pocket the premium.
An example might serve to illustrate the strategy more clearly.
Let’s say that you buy one share of Company X for $100. When you own the stock outright without any associated derivative ownership you’re fully exposed to any upward or downward movement in its price. If the price falls to $75, you’ve lost $25. If the price increases to $125, you’ve gained $25.
But let’s also say that you sell a covered call option at a strike price of $105 for $0.50. By doing this you forfeit the potential to earn any more than $5 on an increase of the stock price. However, you also pocket the premium for the call option, which is $0.50, thereby effectively lowering the cost of owning the stock by the same amount. Now, the stock only costs you $99.50 to hold.
The gist of the strategy is that you’re trading the unlikely chance of significant upside potential for the much more likely occurrence of limited movement in the stock price and reducing the cost of ownership of the stock in the meantime.
30-Delta BuyWrite Index Strategy Performance
We’ve carried out some back-testing research for the 30-Delta BuyWrite Index options trading strategy. The results validated our optimism about this technique.
If you invested $100 in 1986 and followed the BuyWrite strategy, your investment would have grown to $1985 after the passage of 30 years. At the same time, if you invested $100 in 1986 in the S&P 500 Index and simply let your investment ride, your investment would have been worth $1599 after 30 years.
In other words, the simple strategy of selling covered call options each month against stocks you already own dramatically increased the return of those investments. The return on the 30-Delta BuyWrite Index options trading strategy was 24% higher than it was on a standard S&P 500 index strategy.
You could surely be forgiven if the improved performance of the BuyWrite strategy came at the cost of increased risk. After all, heightened volatility is often the price of improved overall performance. But this didn't seem to be the case with BuyWrite. The overall volatility of the BuyWrite portfolio was significantly lower than the volatility of the S&P 500 index portfolio.
Here are the actual numbers:
- S&P Index 500 annualized standard deviation: 15.3%
- BuyWrite Index annualized standard deviation: 13.2%
The volatility of the BuyWrite index was over 2% lower than the volatility of the S&P 500 index. Remember that this is in addition to a 24% increase in the overall performance of the index.
The reduced volatility makes sense when you remember that, along with giving up some upside potential, you reduce your exposure to downward movements in the underlying stock price. You’ve done this by reducing the true cost of owning the stock by the price of the call option contract premium. As a result, you’re less exposed to both upward and downward swings of the stock price.
A Similar Strategy: The CBOE PutWrite Index
A strategy very similar to the BuyWrite options trading strategy, called the CBOE PutWrite Index strategy, draws our attention for many of the same reasons the BuyWrite strategy seems so attractive. The PutWrite strategy increases returns over the S&P 500 benchmark and significantly reduces volatility. To execute the PutWrite technique, the investor:
- Sells a naked put option in the S&P 500 index, and
- Buys treasury bills with the premiums earned.
The payoff diagram is very similar to the BuyWrite Index. While the S&P Index investor would have earned $1599 on $100 invested in 1986, a CBOE PutWrite Index option strategy trader would have earned $1722.
Again, just like with the BuyWrite Index strategy, volatility for this investor decreased at the same time as returns went up significantly. In fact, volatility was even lower for the PutWrite investor than it was for the BuyWrite investor. The annualized standard deviation for investors following the PutWrite was only 10.2%, a full 5.1% lower than an S&P 500 index investor.
Safe Naked Options?
You may have some questions about how a strategy involving a put option can so significantly reduce volatility. After all, you may have heard that naked options (options in which you don’t have a position in the underlying instrument), like the naked put options in the above example, are inherently risky. And risk equals volatility, doesn’t it?
Well, yes and no. It’s true that your downside potential on a naked put is increased beyond what it would be in a covered put option. After all, if the price of the stock were to fall to zero during the duration of the contract, you’d be assigned the stock by the contract holder at the strike price. That would cause you to lose an amount equal to the strike price.
But there are a few key points that people may overlook with naked put options. First, in this strategy, we’re trading naked put options on an index, not an individual stock. It’s extraordinarily unlikely that the S&P 500 index would lose almost all its value over the course of one option contract. Indeed, even in brutal, bear markets, the S&P 500 might lose only half of its value.
Second, as overall market volatility increases and downside potential begins to become more likely, the value of a put option rises dramatically. It’s not unusual for naked puts in volatile bear markets to sell for up to eight to ten times more than they would in a bull market. So, while your downside potential is increased, you’re well compensated for that increase.
Volatility must always be understood as a function of return. In other words, an increased return can justify taking on additional risk as long as that increased return is worth more than the added risk.
Beating the Market
You’ve heard countless people parrot the same words. “You can’t beat the market.” You’ve heard it on the news, at neighborhood barbeques, from your parents, and on financial “news” websites everywhere.
But it is possible to beat the market with the intelligent use of options trades. It doesn’t take a huge amount of capital, sophisticated technology, or an Ivy-league finance degree to do it.
All that’s required is one hour per month and a basic understanding of covered call options. Using only the 30-Delta BuyWrite index strategy you can boost your return over the S&P 500 index by 24%. You can also reduce your volatility by a full 2.1 percentage points.
If you’re looking for something even less volatile you can go with the CBOE PutWrite trading strategy and lower your volatility all the way to 10.2% per year. While you likely won’t do as well as those who follow the BuyWrite strategy, you’ll probably still beat the S&P 500 by a substantial margin as well.