A covered call strategy works particularly well in high-volatility conditions where stocks trade lower or sideways (i.e. presently), and these two ETFs are likely to outperform the markets if these conditions persist.
One of the most-loved charts I assemble each year is my retrospective look at the year in volatility. I already touched on some of the highlights of event volatility in text form, but this is one case in which I believe a picture does a better job of telling the story in the context of a timeline for the entire year.
From a volatility perspective, the first half of 2011 was relatively benign, even though the global social and economic fabric was ripped by Arab spring and the Japanese trio of disasters, which came in the form of the earthquake, tsunami, and nuclear meltdown.
Things were much more promising during the middle of the year when the Greek parliament voted in favor of austerity and the Eurozone agreed to expand the European Financial Stability Facility (EFSF) to EUR 780 million.
For a while, there was considerable angst surrounding the bipartisan politics associated with the US debt ceiling deadline at the beginning of August, but only after the Democrats and Republicans failed to come up with a meaningful debt-reduction deal did investor anxiety shift back to Europe.
Ironically, the downgrade of US debt from AAA to AA+ had very little impact on Treasury securities, which actually began to rally sharply after the downgrade.
When Europe returned to center stage, however, the sovereign debt crisis was escalating rapidly and it was now Italy that was in the crosshairs. The VIX shot up to 48 on August 8 and was regularly above 30 through the end of November, setting a new record for persistent backwardation in the VIX futures in the process.
The VIX was a highwire act throughout August and September, with multiple excursions into the 40s. Even after the S&P 500 index bottomed on October 4 at 1074, the VIX remained stubbornly elevated in October and November before finally falling into the 20s in December. While the SPX was essentially unchanged for the year, the VIX ended 2011 at 23.40, up 31.8% over 2010’s close of 17.75.
At the same time, the VIX futures are calling for a VIX of between 29 and 30 by the midpoint of 2012, suggesting that volatility will climb higher once again in the coming months.
In a year where most asset classes struggled mightily, volatility was one of the few great long positions. With a higher starting point going into 2012, it will be difficult for the VIX to repeat its market-beating performance once again, but if the Eurozone and some of the geopolitical flash points fail to make progress, 2012 may indeed be the year of the VIX.
Try to tell someone who has acrophobia that even the scariest roller coaster ride ends up right where it started and you will likely not assuage any fears. Something similar is at work for hikers, bikers, or mountain climbers: the amount of effort they will need to call upon has nothing to do with ending up at the same elevation they started, but rather, it is the cumulative elevation gain over the course of the trail, road, or mountain. As with many things in life, it is all about the journey, not the destination.
For those who may have a touch of acrophobia, prefer their hikes to put less stress on their cardiovascular system, and want a portfolio that matches the way they wish to experience the world, covered calls, aka “buy-write” strategies, might be the answer.
See related: The Basics of Writing Covered Calls
I have addressed the subject of covered calls and buy-writes a number of times in the past, but essentially this is a strategy which sells calls against an existing (covered call) or new (buy-write) long position in order to generate income off of the underlying.
Covered calls and buy-writes will generally beat the SPX/SPY if stocks decline, move sideways, or rise slowly. The cost to implementing one of these strategies is that if the markets make a sharp bullish move, gains are capped by the covered calls.
In the ETF and ETN world, there are two choices when it comes to buy-write strategies:
PowerShares S&P 500 BuyWrite Portfolio (PBP)
iPath CBOE S&P 500 BuyWrite Index ETN (BWV)
PBP is by far the more liquid of the two alternatives, but some investors may have a reason to prefer BWV’s approach and performance.
In the chart below, I have captured the equity curve of PBP vs. SPY over the course of the second half of 2011, a period in which stocks generally moved sideways and volatility remained high. In other words, a period that was tailor-made for buy-write strategies.
Note that PBP outperformed SPY by 7.7% during this six-month period, and with considerably less volatility and a smaller peak-to-trough drawdown. That’s what alpinists would probably call cumulative elevation loss.
Should high volatility persist in 2012 and stocks end up near where they started the year, both PBP and BWV are likely to outperform the major market indices once again.
By Bill Luby of VixandMore.blogspot.com