Option-Writing Strategies in a Low-Volatility Framework

O ver the last decade, the investment community has witnessed a rapid rise in the number of assets invested in low-volatility strategies.¹ The low-volatility anomaly refers to the empirical observation that portfolios comprising low-beta stocks tend to substantially outperform their higher-beta counterparts. This is a paradoxical outcome from the perspective of the capital asset pricing model (CAPM). Given the increasing popularity of low-volatility strategies, the anomaly is of more than theoretical interest; it offers potentially intriguing investment opportunities.

Several behavioral finance hypotheses have been proposed to explain the low-volatility anomaly. One of the most widely cited explanations--investors' preference for lotterylike gambles--contends that individuals prefer to speculate in stocks with high volatility, especially those with high positive skewness. Another explanation argues that borrowing-constrained investors may use high-beta stocks to increase portfolio risk and expected return. Both behaviors create excess demand for high-beta stocks, which drives their prices up and their returns down relative to low-beta stocks.

Although studies of the low-volatility anomaly have focused almost exclusively on equities, industry practitioners have extended their low-volatility offerings to include covered call option strategies. Call options provide highly leveraged exposure to the upside of the underlying stocks with very modest commitment of capital. They not only have a lotterylike positive skew but can also be employed by leverage-constrained investors as a tool for increasing risk-adjusted portfolio returns. These characteristics suggest that call options may be systematically overpriced. ²

Covered call writing, in which investors sell call options against their stock holdings as a means of enhancing portfolio return and reducing risk,³ is a common investment strategy that has been employed since the establishment of the Chicago Board Options Exchange (CBOE) in 1973. It is often referred to as a buy-write strategy because investors seek to outperform their benchmark indexes bywriting index call options against equity shares that they havebought long. The CBOE introduced the Buy-Write Monthly Index (BXM) in 2002 as a benchmark for evaluating buy-write investment strategies.⁴

Buy-write strategies tend to exhibit risk-return profiles that are similar to those of low-volatility equity portfolios. To date, however, studies on low-volatility investing have not included buy-write strategies. The objective of our research is to determine whether buy-write strategies have risk characteristics that are sufficiently...