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New Kid on the Block

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In September, the Chicago Board Options Exchange (CBOE) and the Nasdaq jointly announced the introduction of the CBOE Nasdaq-100 BuyWrite Index, the BXN. This index joined two other previously introduced BuyWrite indices, the CBOE S&P 500 BuyWrite Index (BXM) and the CBOE Dow Jones Industrials BuyWrite Index (BXD).

The CBOE intends these BuyWrite indices to track the performance of a buy-write strategy for the various indices. A buy-write strategy requires buying a stock or portfolio of stocks and writing covered calls on the stock or portfolio. This strategy comprises one of the two most used options strategies, the other being call buying. The CBOE believed that the development of the indices would induce "more long-term customer interest in, and use of, CBOE index options," according to the 2002 Annual Report. They had their reasons for creating them: investors have another reason. These indices allow a study of how such strategies perform in different markets, helping investors decide if the strategies are right for their investment styles.

Investors didn't necessarily need the indices because theory and market pundits tell them how buy-write strategies will perform. Lawrence G. McMillan devoted more than 50 pages to the buy-write strategy in OPTIONS AS A STRATEGY INVESTMENT, explaining it as a strategy that investors would employ if mildly bullish or neutral. The money received from the written call provides some cushion if stocks declined slightly. The seller or writer of the call would also retain the credit if the stock or portfolio rose only slightly.

It's not as easy as that, though, because there are of course drawbacks. The credit retained would not cushion against too big of a drop, so this would not be a strategy employed if investors believed that a stock or portfolio of stocks would likely take a big hit. In addition, the stock or portfolio would be called away if it had risen above the strike price of the sold call at expiration, so the strategy would also not be appropriate if one anticipated a strong rally rather than a gradual one. The buy-write practitioners' gains would be capped, and those investors would not fully benefit in a strong run that took the price above the sold strike. For all these reasons, McMillan would likely agree with the CBOE's characterization of the strategy as one that tends to outperform the underlying index in a bear market, but underperform in a bullish one, as depicted in the chart below.

P&L Diagram for a Buy-Write Strategy,
Chart from Ibbotson Associates Case Study of the BXM

However, knowing theoretically how the strategy might perform differs from studying a chartable index. Most would choose the chartable index over theory. The CBOE revealed how it would create such indices. Establishing an index that tracks the performance of a buy-write strategy on a particular index involves buying an index portfolio and then writing the near-term covered call option, generally on the third Friday of each month. That would be held until cash-settled on the third Friday of the next month, and then the process would be repeated. The call chosen would be slightly out of the money, the CBOE description states. No adjustments are made on the positions: no stock picking, no puts purchased to offset declines and no rolling up into a higher strike call. The BXM would hold a portfolio of S&P 500 stocks; the BXD, DJIA stocks and the new BXN, NDX 100 stocks. Because no adjustments are made, these indices allow investors to gauge how well such strategies work in each type of market.

The CBOE chose the BXM as the first of the BuyWrite indices to be introduced, so that index has the most accumulated history of the three. Before the index's introduction, the CBOE commissioned Duke University's Professor Robert Whaley to compile data showing how the BXM would have performed from June 1988 through December 2001, a period that encompassed the bull market of the late 90's in addition to the bulk of the bear-market decline that ended in 2002. In addition, Ibbotson Associates performed a study in 2004 that researched the performance of the BXM. The Ibbotson case study followed BXM values from June 1988 through June 2003 and found that the compounded annual return of the BXM Index was 12.39 percent as compared to a 12.20 percent return for the S&P without the covered-call strategy. A further benefit, the study found, was that this index had only two-thirds of the volatility of the SPX and that the risk-adjusted performance was favorable as compared to the SPX, too. Ibbotson researchers concluded that the BXM "has had the best risk-adjusted performance of the major domestic and international equity-based indexes over the past 16 years, and that the index enhances the risk-return tradeoff when added to a portfolio."

Before investors log on to their online brokers' sites to start buying stock and selling calls on them, some cautions are needed. The CBOE's FAQ's on the BXM warn that it might be difficult to reproduce the BXM's returns in real life. Real-life investors are paying commissions, taxes and other transaction costs. This warning is in addition to the one that echoes McMillan's, that traders employing this strategy cannot benefit in any rally beyond the strike price plus the credit received, and that the cushion provided by the credit received will not protect traders from a deep downdraft in the owned stock or portfolio. Of course, the CBOE also cautions that traders employing any options strategy must read and understand the CBOE's "Characteristics and Risks of Standardized Options" and that past performances to not guarantee future results.

What if investors were still interested in employing such a strategy on an index, despite its shortcomings, but not in doing all the work and, more to the point, not in spending all the money to buy the components of an index? The three BuyWrite Indices are not investable indices. Investors can't just buy the BXM, BXD or BXN, so those indices are not going to provide the easy solution.

It's theoretically possible to use a combination of SPY purchases and sold SPX call options to mimic a buy write position on the S&P 500, but most brokerages would not deem this a covered-call position. Most would require hefty capital as margin for that sold call position. Most ETF's have options based on the underlying security, and the QQQQ certainly does, so it would theoretically be possible to replicate the results of the CBOE BXN, the CBOE Nasdaq-100 BuyWrite Index, by purchasing QQQQ's and writing covered calls. The same could be done with the Diamonds (DIA). However, some ETF's are settled with a delivery of shares rather than being cash-settled, so would differ in this manner from the CBOE BuyWrite indices. Besides, this still requires selling calls each month, so it's not the sought-after easy solution.

Some covered-call funds exist, but many allow managers to use discretion to adjust positions, so those funds may not replicate the results of those BuyWrite indices. In 2003, the CBOE licensed Rampart Investment Management to market Rampart BXM, established as an investment vehicle that is meant to replicate the index. The Ibbotson study concluded that the fund did produce results that closely matched the CBOE's BXM. However, at least initially, Rampart intended to market its product to institutional investors and not retail investors.

Two closed-end funds, Madison Claymore's and First Trust's, have since been introduced, both benchmarked to the CBOE BMX. An article by Steven Smith of The Street noted that stakes in their publicly traded shares could be bought and sold, but that their fees were higher than those of most traditional mutual funds. Traders should do their homework if interested in the strategy, Smith advised. The costs of implementing the strategy, through the selling of options twelve times a year against an ETF such as the QQQQ, might actually exceed that of the mutual fund's fees.

Smith proposed that an ETF-type product that replicated the covered-call strategy of the CBOE BuyWrite indices would be eventually be introduced, and he was right. The BEP (XBEPX on the Nasdaq), offered by Nuveen Investments, intends to do just that. The BEP's investment objective is to approximate the performance of the CBOE BXM minus fees and expenses, using a covered call strategy. It was established March 31, 2005, and has varied in price from a high of $20.45 to a low of $18.30. It obviously has little history and almost no information was available. Average daily volume appears low, at about 45,000 on the NYSE. Perhaps other such ETF-type products exist, but a search on Yahoo, Morningstar and other sources for ETF's linked to the BXM turned up no results, although mutual funds and stocks were found.

For now, there may be few good solutions for those who want to employ a buy-write strategy on an index but don't want to do the work. The current environment of much uncertainty in the markets may not be the best to employ such a strategy anyway, as it requires a bullish to neutral outlook to perform well, and it's difficult to settle on an outlook with the current uncertainty.

Suggesting a new investment vehicle was not the purpose of this article, anyway. Suggesting a new tool to be used in considerations about options strategies was the purpose. Anyone considering adopting a covered call strategy might do well to look at charts on the BXM, BXD or the new BXN, studying how they perform in various types of markets. A daily closing price for each is calculated after the close of trading, with that price found at the CBOE website. Quick reference guides to each BuyWrite index can be found there, too.

If considering buy-write strategies, spend some time with the new kid on the block, the BXN, and devote some time to his siblings, the BXM and BXD, too.

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