Generating alpha with call options

Market efficiency is relevant in that it brings risk into the discussion. When money managers can reduce risk through optimal diversification, that can lead to “alpha” generation. Alpha occurs when the rate of return is greater than what is expected for a given level of risk.

Alpha is a core tenet in the financial services sector, as institutional money managers are evaluated constantly on their ability to produce excess risk-adjusted returns. This is even more so in the hedge fund industry, for which long/short strategies incorporate leverage in an attempt to produce high real returns at coincidently high levels of risk. When it works, the numbers are compelling; when it doesn’t, the fallout is severe.

Unfortunately, risk-adjusted returns are rarely discussed among individual investors because most have no grasp about the mathematics of risk. Individual investing is more art than science, as decisions usually are the result of gut feelings rather than mathematical precepts.

Investment advisors who understand the value of diversification should have a meaningful discussion with their clients around the concept of risk vs return, then offer easy to understand strategies that can be adapted to efficient markets.

Covered-call writing is a strategy that consistently generates alpha when the underlying security is a broad index-based exchange-traded fund. For example, consistently writing at-the-money covered calls against, say, S&P 500 depositary receipts (SPY).

However, if you are to suggest a strategy on the basis of what has worked in the past is likely to continue in the future, your strategy must function within the context of market efficiency.

To connect those dots, it’s important to understand that efficiency rests with the belief that a large collection of buyers and sellers making decisions on the basis of known available information will establish a fair market value.

That doesn’t mean the end-value is correct; it means only that the value is based on rational expectations across a large contingent of investors using real money to establish positions.

Based on that proposition, the stock market is a pricing mechanism through which investors come together to evaluate potential return. Investors buy shares when they believe them to be undervalued and sell them because they think that they’re overvalued.

It is the same in the options market – except that this market evaluates risk rather than return. Investors write (sell) options if they believe that the volatility being implied is too high but buy options when implied volatility is understating future risk.

Covered-call writing marries a long position in a market (that prices return) with a short position in another market (that prices risk). If both markets are efficient, then the strategy ought to produce above-average risk-adjusted returns.

Historically, that is exactly what has happened. Various covered-call writing indices – such as the MX covered call writers’ index and the S&P buy/write index – have produced above-average risk-adjusted returns when compared with a simple “buy and hold”-based index strategy in which options are not written.

Taking this discussion full circle, it must be noted that covered-call writing indices measure the performance of selling at-the-money calls against broad-based equities indices – not individual stocks. That’s an important distinction because writing covered calls against individual stocks has produced no evidence supporting the efficiency of markets – nor has that strategy consistently produced alpha.

That apparent disconnection speaks to the challenges of non-systemic risk. Whereas the options market is pretty good at evaluating market risk, it never has been able to quantify company-specific factors efficiently. Non-systemic risks typically drive individual stock prices but theoretically are diversified away within a broad-based index.

As stated earlier, the two points of view are not that far apart.

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