Options Strategy: Addition By Subtraction

“However beautiful the strategy, you should occasionally look at the results." Winston Churchill

The most widely used benchmark for most investors and money managers is the S&P 500 Total Return Index (SPTR). This index tracks the closing price of the S&P 500 adding in dividends.

Many investors try to outperform this index by selection of individual stocks, carefully discarding the perceived under-performers and doubling down on the perceived out-performers. This strategy is also the lifeblood of money managers.

This strategy implies exceptional research capabilities, monitoring individual stocks and other "skills". Since market results indicate that the vast majority of investors and money managers don't out-perform this index, why not look at some proven methods?

Now, no matter what I say, many investors will be convinced that their stock selection will out-perform. So, for these "die-hards" let me offer a "tweak" that has proven to reduce volatility and improve performance..... in addition to whatever else you’re doing, sell naked calls, each month, on the S&P 500 2% out-of-the-money (OTM).

Now, the reason I suggest 2% OTM is that there is an index, ticker BXY, coupled with volumes of research (available at the CBOE Web-Site) that tracks this particular strategy, dating back to 1988. This can certainly give enough data-points to satisfy anyone.

The chart I produce herein, shows the INCREASE IN RETURN by selling 2% OTM calls versus just investing in the SPTR from January 2000 through July 2012. This chart illustrates that selling naked calls 2% OTM over that time-frame would have increased returns by approximately 42%.

Just to be perfectly clear, over this time frame the SPTR grew by 24% and it would have grown by 67% by simply selling calls 2% OTM.

Just so no-one leaves with the wrong idea, I am not suggesting selling naked calls all by themselves, but as part of an overall portfolio strategy. For instance, if the invested portfolio was $200,000, selling 14-15 calls on the SPDR S&P 500 ETF (SPY) would “balance” the portfolio approximately in full. Calls on SPX, itself, would be more difficult to match as it would require 1.5 calls, and options are not available in fractions.

So, it seems that over the last 12 years, one might have handsomely beaten the benchmark SPTR by very simply selling 2% OTM naked calls on top of their portfolio. I say might only because it depends upon how the investor did on their basic portfolio. For instance, if their stock selection underperformed the SPTR by, say 10%, their net over-performance would have only been 32%.

What would have happened if instead of 2% OTM naked calls, At-The-Money (ATM) naked calls were sold? First, the obvious conclusion is that in down markets ATM would have out-performed 2% OTM and in up markets ATM would have under-performed. Here's a comparative chart that just tells us what we should have known.

Once again, this shows the relative performance of the two strategies, that is OTM would have trailed ATM as much as 10% during the first 7 years, but fully recovered and added another 12% during this latest run-up.

The reason I suggested 2% OTM over ATM naked calls is that the premise was to beat the benchmark, not necessarily make the best possible return in any particular situation. In reality, most seasoned investors could vary between the two strategies if they are looking for maximum returns versus out-performance.

Summary: Most investors and money managers simply don't outperform the benchmark S&P 500 Total Return Index. They spend a lot of money, research and effort on what is an elusive goal. On the other hand, there exist time proven strategies, rejected by most investors (presumably for lack of information) that would accomplish this very objective.

Selling 2% OTM naked calls on the S&P 500 is a very simple, yet effective way to "juice up" returns over the long haul. It requires very little effort but some reasonable level of determination and patience. An additional “perk” is a reduction in volatility and an overall safety factor that this article didn’t even go into, but one can research on the CBOE Web-Site.

Conclusion: For all those investors beating their heads against the wall, there exists a very effective strategy to increase returns while reducing risk. Simply sell naked calls, 2% OTM, against the S&P 500. It is simple to understand and simple to execute. For those investors willing to overcome a knowledge and fear barrier, it is well worth pursuing.