Download complete issue - IndexUniverse.com

More documents

Recommendations

Info

any knowledgeable options investor can confirm. Benefits and concerns that are appropriate to coveredcall ETFs include the following: Figure 6 Volume And Open Interest NIFTY January 2012 Expiry Call; Strike Price 4900 Benefits • Lower fees than actively managed ETFs: The costs of acquiring and managing an index fund are meaningfully lower than for actively managed strategies. Thus, while covered-call ETFs on index funds can be expected to have fees slightly higher than for purely passive index ETFs, the fees will be less than those for actively managed ETFs. • Diversification: The lower risk of covered-call writing on the capital market line (Figure 5) suggests this strategy has potential diversification benefits for investment portfolios. • Yield: The systematic capture of call premiums and dividends from covered-call writing both raises the yield and lowers the cost basis of the underlying equity. In Figure 4, it can be seen that returns from covered-call writing dominate those from an index investment right up until the “upper breakeven” point. • Tax treatment: In countries where dividends receive more favorable treatment than capital gains, the aftertax total return on a covered-call ETF will be further enhanced by receipt of dividends. • Intraday trading: Pricing and trading are available intraday. Concerns • Execution costs: Important to understand is that in India, the costs for delivery transactions (Figure 3) are significantly higher than for intraday trades. Covered-call writing does not lend itself to intraday high-frequency trading, so execution costs can create a significant drag on returns. The monthly rolling over of Volume / Open Interest 600,000 500,000 400,000 300,000 200,000 100,000 0 0 10 20 30 40 50 60 Days To Expiration ■ Open Interest ■ Volume Source: National Stock Exchange of India (exchange holiday at 20 days to expiration) Figure 7 Number Of Intraday Covered Calls With RSS Exceeding Mibor* Trade Date ITM Strike OTM Strike December 29, 2012 2,981 10,948 January 25, 2012 3,129 6,933 February 23, 2012 9,953 12,891 April 26, 2012 3,299 8,493 Source: Author’s calculations Note: Using prices for the NIFTY index and NIFTY calls matched to within one second Covered-Call ETF Analysis While the period of our analysis was brief (December 2011 through March 2012), it was sufficient to arrive at useful conclusions regarding the feasibility of ETF creation, especially knowing that the outcome of any lengthier study of risks and returns would be virtually certain to fit consistently with the findings of the key studies. The following steps were taken in this covered-call ETF analysis: In India, the costs for delivery transactions are significantly higher than for intraday trades. Covered-call writing does not lend itself to intraday high-frequency trading, so excecution costs can create a significant drag on returns. options as they expire also adds to the total costs of this semi-passive strategy. • Management fees: The analysis of which options to write and when to write them requires extra care by the ETF manager. The attending costs for this effort must be passed along to the investor. • Underperformance risk: As has been explained, covered-call ETFs can be expected to underperform the index in rapidly rising markets. Step 1: To identify the best options maturity for covered-call writing, trading volume and open interest were captured for near-the-money NIFTY options from which profiles were constructed. A representative profile appears in Figure 6. Similar open-interest and volume statistics for four consecutive expiry dates suggested that the optimal period for covered-call writing was one to four weeks prior to contract maturity. Writing calls with greater than four weeks to maturity was not sensible due to lower liquidity. Writing calls with less than one week to maturity afforded too little absolute return. Step 2: In 2011, NIFTY index options were the secondmost-actively traded equity options contract in the world [Ackworth, 2012]. Despite this comforting statis- 56 March / April 2013
tic, we found it prudent to test the regularity with which profitable covered calls on the NIFTY could be written on any trading day. For this purpose, high-frequency intraday time and options price data was captured and matched to the index price and times within one second. The number of covered calls having an RSS exceed - ing Mibor was recorded on successive expiration trade dates and appears in Figure 7 for contracts both in-themoney (ITM) and out-of-the-money (OTM). Step 3: Following a methodology consistent with BXM construction for January through April 2012 expiry contracts, nearest in-the-money and the nearest out-of-themoney one-month covered calls were written on each of four consecutive option expiry dates and held to the next expiry date. For example, at December expiry (Dec. 29, 2011), two covered calls were separately written for comparison using January 2012 expiry calls, one being slightly in-the-money and one being slightly out-of-the-money, and these positions were held to their Jan. 26 expiry. Step 4: In addition to expiry dates on which steps 1-3 were taken, intermediate sample dates were chosen on which to conduct the same analysis. Results confirm the intraday availability of covered-call writing opportunities was substantial on a regular basis using NIFTY options. As expected, in all three critical regions of the covered-call return profile (Figure 1), observed behavior was consistent with the findings of key studies. In-themoney calls provided greater protection against market declines, while out-of-the-money calls provided greater returns in a rising market. Realized returns were also achieved with less volatility than the index, confirming the diversification benefits of covered-call ETFs. Conclusions With more investors turning their attention to emerging markets, demand is growing for more ways to access them. Pairing covered-call strategies with emerging markets exposure makes sense due to the fact that such strategies tend to dampen volatility and offer some protection from downside risk. However, a developing market may not possess all the features necessary to execute such a strategy. Our findings suggest that currently among BRIC nations, India alone has stock and options markets that make an index covered-call ETF practically achievable. Such an ETF on India’s NIFTY index could provide the valuable benefits of yield enhancement over cash with volatility below that of the index, diversification benefits due to a lower correlation with the index, and a degree of protection against falling markets. Using spot exchange rates, this ETF could also be listed and quoted on local exchanges in Europe, the U.S. or other major financial centers. References Ackworth, W. (March 1, 2012), Annual Volume Survey. Futures Industry, pp. 24-33. Asset Consulting, G. (2012), “An Analysis of Index Option Writing for Liquid Enhanced Risk-Adjusted Returns,” Saint Louis: Asset Consulting Group. CBOE. (2010), BXMDescription-Methodology.pdf, Chicago: Chicago Board Options Exchange. Callan, A. (2006), “An Historical Evaluation of the CBOE S&P 500 BuyWrite Index Strategy,” San Francisco: Callan Associates Inc. EnnisKnupp, H. (2012), “The CBOE S&P 500 BuyWrite Index (BXM),” Lincolnshire: Hewitt EnnisKnupp. Ibbotson, A. (2004). “Highlights from Case Study on BXM Buy-Write Options Strategy,” Chicago: Ibbotson Associates. Kapadia, N. & Szado, E. (2007), “Risk and Return Characteristics of the Buy-Write Strategy on the Russell 2000 Index,” Chicago: Options Industry Council. Slivka, R.T. & Li, X. (September/October 2010). “Hedging and Synthetic Funds Creation in the China Market,” Journal of Indexes, pp. 50-55. INDEXING AND EVERYTHING ELSE The latest industry news and data for ETFs and indexing. Three magazines. Two websites. One independent voice. Subscriptions: www.indexuniverse.com/subscriptions. Advertising and Reprints Inquiries: 415.659.9029 March / April 2013 57
Page 1 and 2:
Plus an interview with Robert Mayna
Page 3 and 4:
www.journalofndexes.com Vol. 16 No.
Page 5 and 6:
McGRAW-HILL You can never have too
Page 7 and 8: ©2013 Morningstar, Inc. All rights
Page 9 and 10: THE POWERSHARES DB COMMODITY INDEX
Page 11 and 12: InsideIndexing risk, return & inDex
Page 13 and 14: kets and currencies—as particular
Page 15 and 16: and the Nasdaq-100 Technology Secto
Page 17 and 18: ficially drive up the price of copp
Page 19 and 20: Over 70 years ago, Benjamin Graham
Page 21 and 22: are high as they do when valuations
Page 23 and 24: the U.K.), but most of the other co
Page 25 and 26: JOI: But PERSI’s strategy does se
Page 27 and 28: www.journalofindexes.com have been
Page 29 and 30: Figure 1 Main Index Providers And R
Page 31 and 32: Figure 5 Five Key Issues With Equit
Page 33 and 34: Figure 8 Important Issues When Sele
Page 35 and 36: indexes that do not rely on a buy-a
Page 37 and 38: Figure 13 Relative Risk of Alternat
Page 39 and 40: For example, in a recent paper, we
Page 41 and 42: value of the Maximum Diversificatio
Page 43 and 44: Despite high t-statistics, statisti
Page 45 and 46: There is a growing body of research
Page 47 and 48: olling annual correlation to the re
Page 49 and 50: Interest rates go up. And down. And
Page 51 and 52: Figure 4 Impact Of Worst-Case Bond
Page 53 and 54: conference schedule the world’s b
Page 55 and 56: While the global financial crisis t
Page 57: [Kapadia & Szado, 2007] and reached
Page 61 and 62: Morningstar Index Funds U.S. Style
Page 63 and 64: Exchange-Traded Dow Jones U.S. Indu
Page 65 and 66: News continued from page 15 Malkiel
Page 67 and 68: ETF Analytics There are over 1,000
show all

Download complete issue - IndexUniverse.com

Create successful ePaper yourself

Delete template?

Save as template?