Fifteen Years of the Russell 2000 Buy-Write

Abstract

Using data from January 18, 1996 to March 31, 2011, we construct and evaluate returns on a buy-write strategy on the Russell 2000 index. The results demonstrate that the strategy has consistently outperformed the Russell 2000 index on a risk-adjusted basis, when implemented with one month to expiration calls and when performance is evaluated using standard performance measures. Over the 182-month period of analysis, the RUT buy-write strategy using 2% out-of-themoney, one-month calls generated higher returns than the underlying index (8.87% versus 8.11%) at about three-quarters of the standard deviation (16.57% versus 21.06%). The outperformance is robust to measures which specifically consider the non-normal distribution of the strategy’s returns. However, the consistent performance advantage does not remain if we utilize two-month to expiration calls. To evaluate the performance in varying market conditions, we break our sample into sub-periods. Specifically, one of the worst market conditions for the buy-write strategy is March 2003 to October 2007, when the Russell 2000 experiences a high sustained growth at a relatively low volatility. Even in this market environment, we find that the 2% out-of-the-money one-month buy-write strategy outperforms the Russell 2000 on a risk-adjusted basis, returning almost the same returns as the index return at three-quarters its volatility. We provide insight into the sources of the performance. On average, the expiration value of written calls exceeds the premium collected and the transaction costs of writing the call at the bid further increases the losses. However, the buy-write strategy benefits by writing calls at an implied volatility that is generally higher than the realized volatility. In fact, we find that the contribution of the volatility risk premium—the difference between implied and realized volatility—is typically larger than the net losses incurred by the call position or the transaction costs. It appears that the existence of the risk premium is critical to the performance of the strategy. In fact, the (Leland’s) alpha of the strategy is typically significantly smaller than the risk premium implying that the buy-write strategy would not provide excess returns in the absence of the risk premium. <b>TOPICS:</b>Other, options, other