I was recently sitting with a broker whom I have known since 1987. He explained how brokers in his office were using covered call writing as an exclusive strategy for their clients because, like so many others in this market, the advisors believe that option writing strategies are the only way to make money in the options game.

The statistics seem to support that position, as some studies have suggested that 80% of all option contracts are worthless upon expiry. So, it’s certainly hard to imagine how an option buyer could profit in that environment. And with time working against the option buyer in particular (not to mention spreads between bid and asked prices), how can option buyers hope to profit on a consistent basis?

These are all valid points, although they ignore the fact that for every option written, there must be someone willing to buy it. You would think that if buyers were consistently losing money, buying would dry up. This would also reduce what someone is willing to pay for an option, with the macro effect being lower option premiums.

In fact, this is exactly what we have seen recently. Option premiums are at 10-year lows, and option buying has, for the most part, been the best strategy over the past two years. It is for this reason that I have been recommending an unusually large number of option buying strategies over the past few months.

Having said that, I do not want to imply that option writing strategies are in crash-and-burn mode. Quite the contrary. Simply because option writing strategies have underperformed option buying strategies, that does not mean that option writing strategies have lost money.

You cannot compare opportunities in the options market on the basis that all trades must end up as a zero-sum game. When an option buyer wins, it does not imply that an option seller loses, nor vice versa. It comes down to how one defines a win and a loss.

There are many instances in which both the option buyer and seller can win. For instance, buying XYZ at $50 per share and writing a six-month XYZ call option at $5 per share is a typical covered writing strategy. If, six months from now, XYZ closes at $58 per share, the covered writer is happy because he or she made a 10% profit, and the call buyer is also happy because his or her call is worth $8 per share for a 60% profit.

What about the XYZ covered writer who holds the position to maturity during a period in which the stock declines to, say, $35 per share? The covered writer has lost $10 per share ($15 per share on the stock, less the $5 premium received). The XYZ option buyer has also lost, but in this case, only the $5 premium per share paid for the call option.

With so many seemingly conflicting points of view, it might help if we were able to look at some long-term studies that have examined buying and writing strategies. There are two covered writing indices we can look at: the Chicago Board Options Exchange buy write index (symbol: BXM), which writes calls on the S&P 500 composite index; and the Montreal Exchange covered call writers index (symbol: MCWX), which writes covered calls on the S&P/TSX 60 iUnits. Both indices have more than 10 years of historical data.

Basically, we know that covered call writing carries less risk than a typical buy-and-hold strategy that does not involve option writing. The BXM index and the MCWX index were both about 70% as volatile as their respective underlying indices.

You would expect that covered call writing, being a lower-risk strategy, should underperform over the long term a buy-and-hold strategy that does not involve option writing, especially during periods when the market is rising, as it did throughout most of the 1990s.

Interestingly, though, the BXM index actually has outperformed the S&P 500 since June 1988. Similar results have been recorded for the MCWX index since 1992.

Because index option writing strategies have produced higher returns with less risk when compared with buy-and-hold strategies, the implication is that index option premiums have been overstating the risk associated with the underlying index during the test period. In other words, index option buyers were paying too high a price to play the game.

@page_break@Further evidence to support this contention can be found by looking at option buying strategies over the same period. If you were buying call options from 1993 — using a strategy of going long in calls plus treasury bills — a $100 investment would have been worth less than $120 by the end of December 2002, with most of that return coming from the interest earned on the T-bills.

Similarly, the same $100 invested long in a T-bill plus a put using S&P 500 index options would have been worth only about $100 at the end of December 2002, a break-even proposition over that 10-year period.

Under either scenario, index option buyers did not fare well. But that assumes the index option buyers were always holding their position to maturity.

In the real world, that rarely happens because option buyers will sell their positions if they will realize a profit.

Thus, you could have instances in which index option buyers could realize a profit at some point during the holding period, and that would not show up in the longer-term statistics.

All this brings us full circle, returning to the self-correcting mechanism of the markets. As expected, because index option writing strategies have fared so well for longer periods, index option premiums have been in steady decline since 2003. And, as one would expect, call buying on the S&P/TSX 60 iUnits has been a successful strategy since 2004, far outpacing the gains of the covered call writing strategy.

Longer term, though, given such compelling evidence that index option writing is a superior strategy to index option buying, it begs the question as to why so many traders continue to buy index options at any price.

The answer seems to be in the simplicity of the decision-making process. Index option traders are willing to play the game because they need only address one question: is the market going to rise or fall? They do not have to sub-divide the decision by trying to pick sectors or specific stocks in the market.

Until we see some expansion in the level of option premiums or a slowdown in commodity prices, which have had such an impact on the Canadian market, I expect we will continue to see potentially profitable call-buying strategies. IE