MX Covered Call Writers' Index (MCWX)
(Since December 20, 1993)
MCWX – XIU
(Last 6 months)
Index value – MCWX
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Introduction to covered call writing
A covered call write (or buy write) is the most common option strategy used by individual investors. With this strategy the investor owns the underlying security – be it a stock, a bond or an index – and sells a call option against the position. By selling the call option, the investor is agreeing to deliver the underlying security to the call buyer at a pre-determined price.
Investors who employ covered call writing as a strategy must understand that it reduces downside risk, it does not eliminate it. Many investors still see covered call writing as a neutral to slightly bearish strategy, believing that it best serves the portfolio in a bear market environment. And to some extent that is true.
Covered call writing does outperform a buy and hold strategy in a bear market. However, the strategy involves ownership of an underlying security. In a bear market, the underlying security will decline in value and so too will the value of the covered call writing strategy. It will not decline as far as the buy and hold strategy, but it will move in the same direction.
Similarly, we would expect covered call writing to underperform in a bull market environment. The covered call writer is obligated to deliver the underlying security to the call buyer at a pre-determined price. In a bull market, that obligation acts as a drag on the overall portfolio performance, because it limits the full extent of an upside move.
MX Covered Call Writers' Index
The Montréal Exchange worked with Richard N Croft (President of R N Croft Financial Group Inc. Investment Counselors / Portfolio Managers, www.croftgroup.com) to construct a passive total return index based on selling near-term close-to-the-money calls against a long position in the iShares of the CDN S&P/TSX 60 Fund.
The near-term (i.e. one month) close-to-the-money call options are written each month, on the Monday following expiration, and are held until the following expiration. At expiration the written options are settled for cash, and on the following Monday, a new one-month close-to-the-money call option is written against the underlying iShares of the CDN S&P/TSX 60 Fund.
Each time a new call option is written, it is assumed to be written at the reported bid price, at the close of trading on the Montréal Exchange on the Monday following an expiration. The premium collected from the sale of the call is added to the portfolio's total value. There is no guarantee that investors would be able to sell at the reported bid price on the Montréal Exchange, at the close of trading on the Monday following an expiration. Investors attempting to replicate the MX Covered Call Writers' Index (symbol MCWX) should discuss with their brokers possible timing and liquidity issues.
The MX Covered Call Writers' Index (symbol MCWX) is a benchmark designed to reflect the return on a portfolio that consists of a long position in the stocks in the iShares (symbol XIU) and a short position in the XIU close-to-the-money call options. The historical return series for the MCWX Index begins December 20, 1993 (the Monday following the December 1993 expiration), the first day that the Chicago Board Options Exchange published data for the Volatility Index.
MX Covered Call Writers' Index construction
While we have available data for the S&P/TSX 60 Index – the forerunner for the tradeable iShares – there was no data for the iShares options. In order to re-create the Index back to December 1993, we calculated a theoretical fair value (TFV) for the close-to-the-money options on the S&P/TSX 60 Index using the Black-Scholes option pricing model.
There are six inputs used in the Black-Scholes option pricing model:
Current price of index
iShares (or S&P/TSX 60 Index adjusted) daily prices were provided by the Montréal Exchange.
The strike price was assumed to be the option closest to the current price of the underlying security. For periods when the iShares were trading below $25 per share, strike prices were assumed to be at $1.00 intervals. For example, if the iShares were trading at $20 per share, we would assume strike prices of $19, $20 and $21.
For periods when the iShares were trading above $25 per share, we assumed strike prices at $2.50 intervals. If the iShares were trading at $28 per share, we would assume strikes prices at $25, $27.50 and $30.
In cases where slightly in-the-money calls were the closest available strike to the current price of the underlying security, we employed a rigid methodology to determine whether slightly in-the-money or slightly out-of-the-money calls would be written. We did not write calls where the strike price was 2% or more in-the-money.
For example, on March 20, 2000, the iShares closed at $56.625. The available April strikes were $55.00 and $57.50. Because the $55.00 strike price was 2.9% in-the-money, we sold the April 57.50 calls.
The risk free interest rate
For this input, we used the closing daily yield on 30-day Government of Canada Treasury bills.
We approximated the dividend yield on the S&P/TSX 60 Index (as well as the iShares), when calculating TFVs for the various option series. The dividend yield was assumed to be 1.6% annually. There was no accounting for the tax implications of dividends versus interest income.
Although the MCWX Index is a total return index, it does not account for dividends that would have been received. Any comparisons between a buy and hold strategy for the iShares and the MCWX Index also excludes dividends.
Volatility was the most difficult input to ascertain. One approach was to simply use the historical volatility of the underlying security as our volatility input. However, historically, the experience in both Canada and the US, is that index options trade at implied volatilities that are generally higher than the actual historical volatility of the underlying index.
That trend can be quantified in the US markets by comparing the Volatility Index (symbol VIX) to the actual historical volatility of the S&P 100 Index (symbol OEX). Historical volatility is calculated as the annualized standard deviation of returns for the underlying security over the preceding 30 days (i.e. 20 trading days).
The CBOE Volatility Index, on the other hand, measures the implied volatility based on the actual prices for S&P 100 Index options. The CBOE Volatility Index has data back to December 1993. From December 16, 1993 to October 7, 2002, we counted 2,216 daily observations related to the actual historical volatility for the S&P 100 Index. There were also 2,216 available observations for the VIX. On 2,003 of those observations (90.39% or all observations), the VIX had a higher closing value than the actual historical volatility of the S&P 100 Index. On average, over that observation period, the VIX value was 1.45 times the value of the historical volatility as calculated for the S&P 100 Index.
Further studies showed that from December 1993 to October 2002, the S&P/TSX 60 Index had a positive correlation (0.75 correlation coefficient) with the S&P 100 Index. Suggesting that on average, both underlying indices tended to move in similar directions at the same time. There was however, some variance in the degree of daily moves when comparing the S&P/TSX 60 Index to the S&P 100 Index. Over the observation period, the S&P 100 Index was slightly more volatile on average, that the S&P/TSX 60 Index.
Given those observations, it was decided that the daily volatility input for the MX Covered Call Writers Index would be based on a multiple of the observed VIX implied versus actual historical volatility on the S&P 100 Index.
For example, on July 8, 1996, the annualized 30-day historical volatility on the S&P 100 Index was 15.9% (note on July 8, 1996, the S&P/TSX 60 Index had an implied volatility of 8.1%).
On that particular date, the VIX closed at 20.9%, or 1.3 times the level of the actual historical volatility for the S&P 100 Index. The 1.3 becomes the multiple used to calculate the TFV for the S&P/TSX 60 Index options on that day.
So, coming to full circle, we multiplied the actual 30-day historical volatility for the S&P/TSX 60 Index (i.e. 8.1%) by the 1.3 multiple as ascertained from the implied versus actual volatility for the S&P 100 Index to arrive at an implied volatility assumption for the S&P/TSX 60 Index of 10.6%. We input the 10.6% assumption in the Black-Scholes formula for that day, and utilized the same methodology for all other days until iShares S&P/TSX 60 Index began trading. Once iShares S&P/TSX 60 Index options began trading, we used the actual prices form the Montréal Exchange.
Time to expiration
The time to expiration is calculated as the total number of days between the Monday following a series expiration to the next expiration date. The expiration date for each option series is the Saturday following the third Friday of the expiration month.
When inputting these six factors into the model, the formula provides a TFV. Current daily index calculations are not determined by the model, but are based on the actual daily closing prices for the underlying index and the written option, as settled on the Montréal Exchange.
A new iShares covered call write is initiated on the Monday following each Friday expiration. The MX Covered Call Writers' Index is based on a portfolio of 5,000 shares of the iShares. Against that portfolio, we write 50 one-month close-to-the-money calls, covering the entire position. The number of shares was rounded to reflect a beginning portfolio value of $108,290.
The MCWX Index does not account for transaction costs. Investors should recognize that trades in the Index occur every month and transaction costs can have a meaningful impact on the value of the Index.
A series of new indices
In recent years, the Montréal Exchange has received general interest from institutional and individual customers as to the performance attributes associated with various option strategies. The MX has been encouraged to create passive benchmark indices to reflect these performance attributes. The Montréal Exchange believes that the introduction of the MX Covered Call Writers' Index (MCWX) and the MX Covered Straddle Writers' Index (MPCX) could lead to more long-term customer interest in and use of Montréal Exchange listed options.
Price levels of MX indices
Prices for the MX Covered Call Writers' Index (MCWX) and the MX Covered Straddle Writers' Index (MCPX) are available from this website and from quote vendors that provide options data. The price level for both MX Indices was set to 100 on December 20, 1993.
Tradeable, investable alternatives
In October 2002, the Montréal Exchange began disseminating MX Covered Call Writers' Index (MCWX) and MX Covered Straddle Writers' Index (MCPX) prices as a general indication of a hypothetical iShares buy-write strategy. Based on theses indices, other products might be created such as ETFs, futures, hedge funds or mutual funds.
The Montréal Exchange does not provide specific recommendations for mutual funds, but investors interested in these strategies might research the returns and risks of mutual funds that engage in option writing strategies for a portion of their investment portfolios.
The added income from the covered calls in an option writing strategy has historically provided a cushion in times of flat to declining markets. When the underlying market is rising rapidly, option writing strategies generally underperformed a buy and hold approach for the iShares.
The most attractive feature in an option writing strategy is the marked reduction in the volatility of the overall portfolio. The daily standard deviation for all observations in the MX Covered Call Writers' Index was 0.83%, for the MX Covered Straddle Writers' Index it was 0.81% versus 1.15% for a buy and hold strategy using the iShares.
Covered call writing strategy
For example, assume a position where the investor holds 100 shares of XYZ at $50 per share. The investor sells the XYZ six-month 50 call for a net premium of $5 per share ($500 per contract). In this example, the covered writer has agreed to sell the 100 shares to the call buyer at $50 per share until the option expires. For agreeing to this, the call buyer will pay $5 per share in premium. The premium is retained by the covered writer no matter where the stock ends up in six months.
Because the covered writer owns the underlying shares in this strategy, he should be mildly bullish, or at the very least, neutral on the prospects for the underlying stock. In the example cited, one of three outcomes will occur until expiration. The stock can rise above $50 per share. In that event, the call will be exercised, the call buyer will pay $50 per share, and the covered writer will deliver the 100 shares of XYZ.
The stock can remain unchanged for the life of the option. In this unlikely event, the option will expire worthless. The covered writer is no longer under an obligation to sell shares at $50. The covered call writer still owns the 100 shares of XYZ, and the $5 premium received when the option was sold, is retained by the covered writer. The stock can decline below $50 per share between the time the call was sold and the expiration date. In this case, the covered writer is better off than the investor who never sold the call. Why? Because the initial $5 per share premium received can be applied against the initial purchase price of the stock. The premium reduces the cost of XYZ by $5 per share.
The covered call establishes a set of parameters. In the XYZ example, the writer has limited upside potential to the strike price of the option, plus the $5 premium ($50 + $5 = $55). At the same time, he has reduced the cost base of the stock by the premium received. In this case, the net cost to buy XYZ stock was reduced from $50 to $45. That latter point is critical. Covered call writing does not eliminate downside risk; it only offsets some of the decline.
Keeping with the profit and loss theme, Table 1 examines the profit and loss potential from the XYZ covered call write at different price levels. Prices quoted are assumed to be on last trading day for XYZ options.
|XYZ stock price||Total cost stock – Call||Stock value at expiry||Call value at expiry||Profit (Loss)|
Figure 1 characterizes the covered call write in graphic form. Note how the profit/loss line truncates from left to right above the breakeven axis. Further note how the call reduces the risk of holding the shares. As the price of the stock declines so too does the value of the total portfolio (stock plus call). However, at each price point, the covered writer has a smaller loss than the investor who holds the stock but did not sell a call option against the position. That is depicted in the chart in that losses occur to the left of where they would with the long stock position.
The daily closing price of the MCWX Index is calculated and disseminated by R N Croft Financial Group Inc. Changes in the value of the Index are based on daily changes reflected in the closing prices for the iShares and the written series of call options. Prices for MCWX are updated on the Montréal Exchange website weekly.