In recent years, there has
been increased interest from institutional and individual investors about the performance attributes of various option strategies.

One of the most asked questions, for example, is: how does covered call writing perform over the course of a business cycle, and is it best used at market tops or market bottoms?

To address this issue, I had the opportunity to develop two passive benchmark indices that reflect the performance attributes of two option strategies — the more common covered call write and the lesser known straddle write — for the Montreal Exchange, the market on which Canadian derivatives trade.

This work was completed in 2002, and the indices were born: the MX covered call writers index (symbol: MCWX) and the MX straddle writers index (symbol: MPCX).

Both indices are passive, in the sense that no attempt was made to alter the structure of the strategies for specific market environments.

The MCWX is a passive total-
return index based on selling near-term (i.e., one month), close-to-the-money calls against a long position in S&P/TSX 60 iShares (symbol: XIU).

The MCWX is a benchmark designed to reflect the return on a portfolio consisting of a long position in Canadian stock (represented by XIU) and a short position in close-to-the-money XIU call options.

The strategy’s most telling feature may be the ability of writing covered call options to reduce risk. Against a buy-and-hold approach, covered call writing produces a marked reduction in the portfolio’s volatility. The annual standard deviation for the MCWX has been 11.55%, vs 16.47% for a buy-and-hold strategy using the XIU.

Note, though, that the MCWX does not account for transaction costs, which can have an impact on this strategy’s performance. But, even with transaction costs, covered call writing has been a winner in terms of risk-adjusted performance measured against a buy-and-hold approach.

The added income from writing covered calls has historically provided a cushion in flat to declining markets. Although the ceiling imposed by the short call had a negative impact on performance when the Canadian market was rising rapidly, it reduced risk and added return in the bear market of 2000-03.

Here is how it works:

The MCWX is based on a portfolio of 5,000 shares of XIU. Against that portfolio, we write 50 near-term, close-to-the-money XIU calls covering the entire position. (The number of shares was rounded to reflect a beginning portfolio value of $108,290 as of Dec. 20, 1993, the date chosen on which to base returns.)

For the MCWX, one-month, close-to-the-money XIU call options are written each month on the Monday following the expiration of the previous series of XIU options and are held until the following expiration date. At expiration, these options are settled for cash. Then, on the following Monday, new one-month, close-to-the-money call XIU options are written against the underlying XIU.

Each time a new XIU call option is written, it is assumed to be written at the reported bid price of XIU at the close of trading on the MX on the Monday following the expiration of the previous series of XIU options. The premium collected from the sale of the XIU call is added to the MCWX portfolio’s total value.

Changes in the value of the MCWX are based on daily changes in the closing prices for XIU and the written series of XIU call options. Values for the MCWX are updated weekly on the MX’s Web site.

Daily data on the performance of the MCWX are available from December 1993 to the present on the MX’s Web site (www.m-x.ca/accueil_en.php), and can be downloaded into a Microsoft Excel spreadsheet.

The MPCX, on the other hand, provides a so-called “straddle” by simultaneously selling a close-to-the-money XIU call (i.e., the call with a strike price closest to the current value of the underlying XIU) against a long position in XIU, and a close-to-the-money XIU put (i.e., the put with a strike price closest to the current value of the underlying XIU) that is secured by cash.

As with the MCWX, these near-term, close-to-the-money XIU call and put options are written each month on the Monday following the expiration of the previous series of XIU options and held until the following expiration date, when the written XIU options are settled for cash.

@page_break@Advisors can use these indices to measure the performance of actively managed options-writing funds or to evaluate options writing against other income strategies. IE