1.

4: Call Overwriting 15

1.4: CALL OVERWRITING

For a directional investor who owns a stock (or index), call overwriting by selling an
OTM call is one of the most popular methods of yield enhancement. Historically,
call overwriting (otherwise known as buy-write, as the stock is bought but a call is
written against it) has been a profitable strategy due to implied volatility usually
being overpriced. However, call overwriting does underperform in volatile, strongly
rising equity markets. Overwriting with the shortest maturity is best, and the strike
should be slightly OTM for optimum returns.

IMPLIED VOLATILITY IS USUALLY OVERPRICED

The implied volatility of options is on average 1-2pts above the volatility realised over the
life of the option. This ‘implied volatility premium’ is usually greater for indices than for
single stocks. As we can see no reason why these imbalances will fade, we expect call
overwriting to continue to outperform on average. The key imbalances are:

 Option buying for protection. In the same way that no one buys car insurance because
they think it is a good investment, investors are happy buying expensive protection to
protect against downside risks.
 Unwillingness to sell low premium options causes market makers to raise their
prices (selling low premium options, like selling lottery tickets, has to be done on a large
scale to be attractive).
 High gamma of near-dated options has a gap risk premium (risk of stock jumping,
either intraday or between closing and opening prices).
 Index implieds lifted by structured products. Structured products are often based on
an index, and can offer downside protection. This lifts index implied relative to single
stock implied. Also protection is usually bought on an index to protect against macros
risks. It is rare to protect a single stock position (if an investor is worried about
downside in a stock they usually do not buy it to begin with).

BUY-WRITE BENEFITS FROM SELLING EXPENSIVE VOL

Short-dated implied volatility has historically been overpriced 2 due to the above supply and
demand imbalances. In order to profit from this characteristic, a long investor can sell a call
against a long position in the underlying of the option. Should the underlying perform well
and the call be exercised, the underlying can be used to satisfy the exercise of the call. As
equities should be assumed to have, on average, a positive return, it is best to overwrite with
a slightly OTM option to reduce the probability of the option sold expiring ITM.

2 We note that implied volatility is not necessarily as overpriced as would first appear. For more detail,
see the section 3.1 Implied Volatility Should Be Above Realized Volatility.
16 CHAPTER 1: OPTIONS

Figure 5. Short Call Call Overwriting (or Buy Write)

Return Return
20% 150%
Call overwriting profit is capped
at the strike of short call
140%
10% 130%
120%
0%
110%
80% 90% 100% 110% 120% 130% 140% 150%
-10% Strike 100%
90%
-20% 80%
70%
-30% 60%
50%
-40% 80% 90% 100% 110% 120% 130% 140% 150%
Short call Equity Equity + short call Strike

Call overwriting is a useful way to gain yield in flat markets

If markets are range trading, or are approaching a technical resistance level, then selling a call
at the top of the range (or resistance level) is a useful way of gaining yield. Such a strategy
can be a useful tactical way of earning income on a core strategic portfolio, or potentially
could be used as part of an exit strategy for a given target price.

Selling at target price enforces disciplined investing

If a stock reaches the desired target price, there is the temptation to continue to own the
strong performer. Over time a portfolio can run the risk of being a collection of stocks that
had previously been undervalued, but are now at fair value. To prevent this inertia diluting
the performance of a fund, some fund managers prefer to call overwrite at their target price
to enforce disciplined investing, (as the stock will be called away when it reaches the target).
As there are typically more Buy recommendations than Sell recommendations, call
overwriting can ensure a better balance between the purchase and (called away) sale of
stocks.
1.4: Call Overwriting 17

PUT UNDERWRITING HAS SIMILAR PROFILE

Figure 5 above shows the profiles of a short call and of a long equity with an overwritten
call. The resulting profile of call overwriting is similar to that of a short put (Figure 6 below);
hence, call overwriting could be considered similar to stock replacement with a short put (or
put underwriting). Both call overwriting and put underwriting attempt to profit from the fact
that implied volatility, on average, tends to be overpriced. While selling a naked put is seen as
risky, due to the near infinite losses should stock prices fall, selling a call against a long equity
position is seen as less risky (as the equity can be delivered against the exercise of the call).

Figure 6. Put Underwriting

Return
20%

10%

0%
50% 60% 70% 80% 90% 100% 110% 120% 130% 140% 150%
Strike
-10%

-20%

-30%

-40%
Short put

1×2 call spreads are useful when a bounce-back is expected

If a near zero cost 1×2 call spread (long 1×ATM call, short 2×OTM calls) is overlaid on a
long stock position, the resulting position offers the investor twice the return for equity
increases up to the short upper strike. For very high returns the payout is capped, in a similar
way as for call overwriting. Such positioning is useful when there has been a sharp drop in
the markets and a limited bounce back to earlier levels is anticipated. The level of the bounce
back should be in line with or below the short upper strike. Typically, short maturities are
best (less than three months) as the profile of a 1×2 call spread is similar to a short call for
longer maturities.
18 CHAPTER 1: OPTIONS

Figure 7. Booster (1×2 Call Spread) Call Overwriting with Booster

Return Return Call overwriting with booster profit is
30% 150% capped at the strike of the two short calls
140%
20% 130%
120%
10% 110%
100%
90%
0%
80% 90% 100% 110% 120% 130% 140% 150% 80%
Strike 70%
-10%
60%
50%
-20% 50% 70% 90% 110% 130% 150%
Booster (1x2 call spread) Equity Equity + booster Strike

CALL OVERWRITING IS BEST DONE ON AN INDEX

Many investors call overwrite on single stocks. However, single-stock implied volatility
trades more in line with realised volatility than index implieds. The reason why index
implieds are more overpriced than single-stock implieds is due to the demand from hedgers
and structured product sellers. Call overwriting at the index level also reduces trading costs
(due to the narrower bid-offer spread).

The CBOE has created a one-month call overwriting index on the S&P500 (BXM index),
which is the longest call overwriting time series available. It is important to note that the
BXM is a total return index; hence, it needs to be compared to the S&P500 total return
index (SPXT Bloomberg code) not the S&P500 price return (SPX Bloomberg code). As can
be seen in Figure 8 below, comparing the BXM index to the S&P500 price return index
artificially flatters the performance of call overwriting.
Figure 8. S&P500 and S&P500 1M ATM Call Overwriting Index (BXM)
Price (rebased)
1100
1000 BXM is a total return index, so needs to be compared
to S&P500 total return index for a fair comparison
900
800
700
600
500
400
300
200
100
0
1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
BXM (1m 100% Buy Write) S&P500 S&P500 total return
1.4: Call Overwriting 19

Call overwriting performance varies according to conditions

On average, ATM index call overwriting has been a profitable strategy. However, there have
been periods of time when it is has been unprofitable. The best way to examine the returns
under different market conditions is to divide the BXM index by the total return S&P500
index (as the BXM is a total return index).

Figure 9. S&P500 1M ATM Call Overwriting Divided by S&P500 Total Return

Relative performance Call overwriting performance depends on market environment
140 (rebased)
2009
130 trough
2003
trough
120
Call overwriting Start of late 90's
outperforms bull market
110
Credit
crunch
100 Asian
crisis TMT
90 peak
Call overwriting
underperforms
80
Outperform Significantly Breakeven Significantly Underperform Significantly Significantly
Underperform Outperform Outperform Underperform
70
1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
BXM (1m 100%) / S&P500 total return

Overwriting underperforms in bull markets with low volatility

Since the BXM index was created, there have been seven distinct periods (see Figure 9
above), each with different equity and volatility market conditions. Of the seven periods, the
two in which returns for call overwriting are negative are the bull markets of the mid-1990s
and middle of the last decade. These were markets with very low volatility, causing the short
call option sold to earn insufficient premium to compensate for the option being ITM.

It is important to note that call overwriting can outperform in slowly rising markets, as the
premium earned is in excess of the amount the option ends up ITM. This was the case for
the BXM between 1986 and the mid-1990s. It is difficult to identify these periods in advance
as there is a very low correlation between BXM outperformance and the earlier historical
volatility.

LOWER EXPOSURE TO EQUITY RISK PREMIUM

We note that while profits should be earned from selling an expensive call, the delta (or
equity sensitivity) of the long underlying short call portfolio is significantly less than 100%
(even if the premium from the short call is reinvested into the strategy). Assuming that
equities are expected to earn more than the risk free rate (ie, have a positive equity risk
premium), this lower delta can mean more money is lost by having a less equity-sensitive
portfolio than is gained by selling expensive volatility. On average, call overwriting appears
20 CHAPTER 1: OPTIONS

to be a successful strategy, and its success has meant that it is one of the most popular uses
of trading options.
OVERWRITING WITH NEAR-DATED OPTIONS IS BEST
Near-dated options have the highest theta, so an investor earns the greatest carry from call
overwriting with short-dated options. It is possible to overwrite with 12 one-month options
in a year, as opposed to four three-month options or one 12-month option. While
overwriting with the shortest maturity possible has the highest returns on average, the
strategy does have potentially higher risk. If a market rises one month, then retreats back to
its original value by the end of the quarter, a one-month call overwriting strategy will have
suffered a loss on the first call sold but a three-month overwriting strategy will not have had
a call expire ITM. However, overwriting with far-dated expiries is more likely to eliminate
the equity risk premium the investor is trying to earn (as any outperformance above a certain
level will be called away).

Figure 10. Call Overwriting SX5E with One-Month Calls of Different Strikes
3.0%

104%
103% 2.5%

Call overwriting return - index return

105%
102%
106%
2.0%
101%
108%
1.5%

110%
100% 1.0%
Exact peak strike for overwriting
depends on period of backtest 0.5%

Index
0.0%
-8% -7% -6% -5% -4% -3% -2% -1% 0%
Call overw riting volatility - index volatility

BEST RETURNS WITH SLIGHTLY OTM OPTIONS

While overwriting with near-dated expiries is clearly superior to overwriting with far-dated
expiries, the optimal choice of strike to overwrite with depends on the market environment.
As equities are expected, on average, to post a positive return, overwriting should be done
with slightly OTM options. However, if a period of time where equities had a negative return
is chosen for a back-test, then a strike below 100% could show the highest return. Looking
1.4: Call Overwriting 21

at a period of time where the SX5E had a positive return shows that for one-month options
a strike between 103%-104% is best (see Figure 10 above).

Typically call overwriting with c25% delta call options is best

For three-month options, the optimal strike is a higher 107%-108%, but the outperformance
is approximately half as good as for one-month options. These optimal strikes for
overwriting could be seen to be arguably high, as recently there have been instances of
severe declines (TMT bubble bursting, Lehman bankruptcy), which were followed by
significant price rises afterwards. For single-stock call overwriting, these strikes could seem
to be low, as single stocks are more volatile. For this reason, many investors use the current
level of volatility to determine the strike or choose a fixed delta option (eg, 25%).

OVERWRITING REDUCES VOLATILITY

While selling an option could be considered risky, the volatility of returns from overwriting a
long equity position is reduced by overwriting. This is because the payout profile is capped
for equity prices above the strike. An alternative way of looking at this is that the delta of the
portfolio is reduced from 100% (solely invested in equity) to 100% less the delta of the call
(c50% depending on strike). The reduced delta suppresses the volatility of the portfolio.

Risk reduction less impressive if Sortino ratios are used

We note that the low call overwriting volatility is due to the lack of volatility to the upside, as
call overwriting has the same downside risk as a long position. For this reason, using the
Sortino ratio (for more details, see the section A11 Sortino Ratio in the Appendix) is likely to be
a fairer measure of call overwriting risk than standard deviation, as standard deviation is not
a good measure of risk for skewed distributions. Sortino ratios show that the call overwriting
downside risk is identical to a long position; hence, call overwriting should primarily be done
to enhance returns and is not a viable strategy for risk reduction.

Optimal strike is similar for single stocks and indices

While this analysis is focused on the SX5E, the analysis can be used to guide single-stock call
overwriting (although the strike could be adjusted higher by the single-stock implied divided
by SX5E implied).
22 CHAPTER 1: OPTIONS

ENHANCED CALL OVERWRITING IS DIFFICULT

Enhanced call overwriting is the term given when call overwriting is only done
opportunistically or the parameters (strike or expiry) are varied according to market
conditions. On the index level, the returns from call overwriting are so high that enhanced
call overwriting is difficult, as the opportunity cost from not always overwriting is too high.
For single stocks, the returns for call overwriting are less impressive; hence, enhanced call
overwriting could be more successful. An example of single-stock enhanced call overwriting
is to only overwrite when an implied is high compared to peers in the same sector. We note
that even with enhanced single-stock call overwriting, the wider bid-offer cost and smaller
implied volatility premium to realised means returns can be lower than call overwriting at the
index level.

Enhanced call overwriting returns likely to be arbitraged away

Should a systematic way to enhance call overwriting be viable, this method could be applied
to volatility trading without needing an existing long position in the underlying. Given the
presence of statistical arbitrage funds and high frequency traders, we believe it is unlikely that
a simple automated enhanced call overwriting strategy on equity or volatility markets is likely
to outperform vanilla call overwriting on an ongoing basis.
1.5: Protection Strategies Using Options 23

1.5: PROTECTION STRATEGIES USING OPTIONS

For both economic and regulatory reasons, one of the most popular uses of options is
to provide protection against a long position in the underlying. The cost of buying
protection through a put is lowest in calm, low-volatility markets, but in more
turbulent markets the cost can be too high. In order to reduce the cost of buying
protection in volatile markets (which is often when protection is in most demand),
many investors sell an OTM put and/or an OTM call to lower the cost of the long
put protection bought.

CHEAPEN PROTECTION BY SELLING OTM PUT & CALL

Buying a put against a long position gives complete and total protection for underlying
moves below the strike (as the investor can simply put the long position back for the strike
price following severe declines). The disadvantage of a put is the relatively high cost, as an
investor is typically unwilling to pay more than 1%-2% for protection (as the cost of
protection usually has to be made up through alpha to avoid underperforming if markets do
not decline). The cost of the long put protection can be cheapened by selling an OTM put
(turning the long put into a long put spread), by selling an OTM call (turning put protection
into a collar), or both (resulting in a put spread vs call, or put spread collar). The strikes of
the OTM puts and calls sold can be chosen to be in line with technical supports or resistance
levels.

Figure 11. Put Put spread

Return Return Call spreads are cheaper
30%
Puts give downside 30%
exposure and the maximum than calls, but only give
loss is the premium paid partial upside exposure
20% 20%

10% 10%

0% 0%
60% 70% 80% 90% 100% 110% 120% 130% 60% 70% 80% 90% 100% 110% 120% 130%
-10% Strike -10% Strike

-20% -20%

-30% -30%
Put Put spread
24 CHAPTER 1: OPTIONS

 Puts give complete protection without capping performance. As puts give such
good protection, their cost is usually prohibitive unless the strike is low. For this reason,
put protection is normally bought for strikes around 90%. Given that this protection will
not kick in until there is a decline of 10% or more, puts offer the most cost-effective
protection only during a severe crash (or if very short-term protection is required).
 Put spreads only give partial protection but are cost effective. While puts give
complete protection, often only partial protection is necessary, in which case selling an
OTM put against the long put (a put spread) can be an attractive protection strategy.
The value of the put sold can be used to either cheapen the protection or lift the strike
of the long put.
 Collars can be zero cost as they give up some upside. While investors appreciate the
need for protection, the cost needs to be funded through reduced performance (or less
alpha) or by giving up some upside. Selling an OTM call to fund a put (a collar) results
in a cap on performance. However, if the strike of the call is set at a reasonable level, the
capped return could still be attractive. The strike of the OTM call is often chosen to give
the collar a zero cost. Collars can be a visually attractive low (or zero) cost method of
protection as returns can be floored at the largest tolerable loss and capped at the target
return. A collar is unique among protection strategies in not having significant volatility
exposure, as its profile is similar to a short position in the underlying. Collars are,
however, exposed to skew.
 Put spread collars best when volatility is high, as two OTM options are
sold. Selling both an OTM put and OTM call against a long put (a put spread collar) is
typically attractive when volatility is high, as this lifts the value of the two OTM options
sold more than the long put bought. If equity markets are range bound, a put spread
collar can also be an attractive form of protection. Put spread collars are normally
structured to be near zero cost (just like a collar).

Figure 12. Collar Put spread collar

Return Return Call spread vs put is often attractive in
30%
Collars (sometimes known as risk reversals) 30%
give downside exposure, but are also suffer high volatility environments, as two OTM
20% losses to the upside 20%
options are sold for every option bought

10% 10%

0% 0%
60% 70% 80% 90% 100% 110% 120% 130% 60% 70% 80% 90% 100% 110% 120% 130%
-10% Strike -10% Strike

-20% -20%

-30% -30%
Collar Put spread collar
1.5: Protection Strategies Using Options 25

Portfolio protection is usually done via indices to lower cost

While an equity investor will typically purchase individual stocks, if protection is bought then
this is usually done at the index level. This is because the risk the investor wishes to hedge
against is the general equity or macroeconomic risk. If a stock is seen as having excessive
downside risk, it is usually sold rather than a put bought against it. An additional reason why
index protection is more common than single stock protection is the fact that bid-offer
spreads for single stocks are wider than for an index.

Figure 13. Option Strategy for Different Market and Volatility Views
PROTECTION REQUIRED
Full Partial
UPSIDE
Put (usually expensive) Put spread (cheaper)
Return Return
130% Put protection floors returns at strike Put spread gives partial protection
130%
and keeps upside participation at lower cost than put
120% 120%
110% 110%
Uncapped 100% 100%
90% 90%
80% 80%
70% 70%
60% 70% 80% 90% 100% 110% 120% 130% 60% 70% 80% 90% 100% 110% 120% 130%
Equity Equity + put Strik Equity Equity + put spread Strike

Collar (zero cost) Put spread collar(zero cost)

Return Return Put spread collar gives partial protection,
A collar floor returns like a put, 130%
130% and caps returns
but also caps returns
120% 120%

Capped upside 110% 110%

100% 100%

90% 90%

80% 80%
70% 70%
60% 70% 80% 90% 100% 110% 120% 130% 60% 70% 80% 90% 100% 110% 120% 130%
Equity Equity + collar Strik Equity Strike

Partial protection can give attractive risk reward profile

For six-month maturity options, the cost of a 90% put is typically in line with a 95%-85%
put spread (except during periods of high volatility, when the cost of a put is usually more
expensive). Put spreads often have an attractive risk-reward profile for protection of the
same cost, as the strike of the long put can be higher than the long put of a put spread.
Additionally, if an investor is concerned with outperforming peers, then a c10%
outperformance given by a 95%-85% put spread should be sufficient to attract investors
(there is little incremental competitive advantage in a greater outperformance).
26 CHAPTER 1: OPTIONS

Implied volatility is far more important than skew for put-spread pricing
A rule of thumb is that the value of the OTM put sold should be approximately one-third
the value of the long put (if it were significantly less, the cost saving in moving from a put to
a put spread would not compensate for giving up complete protection). While selling an
OTM put against a near-ATM put does benefit from selling skew (as the implied volatility of
the OTM put sold is higher than the volatility of the near ATM long put bought), the effect
of skew on put spread pricing is not normally that significant (far more significant is the level
of implied volatility).

Collars are more sensitive to skew than implied volatility

Selling a call against a long put suffers from buying skew. The effect of skew is greater for a
collar than for a put spread, as skew affects both legs of the structure the same way (whereas
the effect of skew on the long and short put of a put spread partly cancels). If skew was flat,
the cost of a collar typically reduces by 1% of spot. The level of volatility for near-zero cost
collars is not normally significant, as the long volatility of the put cancels the short volatility
of the call.

Capping performance should only be used when a long rally is unlikely

A collar or put spread collar caps the performance of the portfolio at the strike of the OTM
call sold. They should only therefore be used when the likelihood of a strong, long-lasting
rally (or significant bounce) is perceived to be relatively small.

Bullish investors could sell two puts against long put

If an investor is bullish on the equity market, then a protection strategy that caps
performance is unsuitable. Additionally, as the likelihood of substantial declines is seen to be
small, the cost of protection via a put or put spread is too high. In this scenario, a zero cost
1×2 put spread could be used as a pseudo-protection strategy. The long put is normally
ATM, which means the portfolio is 100% protected against falls up to the lower strike, and
gives partial protection below that until the breakeven. A loss is only suffered if the equity
market falls below the breakeven.

1×2 put spreads only give pseudo-protection

We do not consider 1x2 put spreads to offer true protection, as during severe declines it will
suffer a loss when the underlying portfolio is also heavily loss making. The payout of 1×2
put spreads for maturities of around three months or more is initially similar to a short put,
so we consider it to be a bullish strategy. However, for the SX5E a roughly six-month zero-
cost 1×2 put spread, whose upper strike is 95%, has historically had a breakeven below 80%
and declines of more than 20% in six months are very rare. As 1×2 put spreads do not
provide protection when you need it most, they could be seen as a separate long position
rather than a protection strategy.
1.5: Protection Strategies Using Options 27

Figure 14. 1×2 Put Spread 1×2 Put Spread Pseudo-Protection

Return 1x2 put spread is usually long an ATM option Return
30%
1x2 put spread offers pseudo-protection
150%
and lower strike chosen to be zero cost as the structure is loss making for very
140%
low values of spot
20% 130%
120%
10% 110%
100%
90%
0%
50% 60% 70% 80% 90% 100% 110% 120% 80%
Strike 70%
-10%
60%
50%
-20% 50% 60% 70% 80% 90% 100% 110% 120%
1x2 put spread Equity Equity + 1x2 put spread Strike

PROTECTION MUST BE PAID FOR: QUESTION IS HOW?

If an investor seeks protection, the most important decision that has to be made is how to
pay for it. The cost of protection can be paid for in one of three ways. Figure 15 below shows
when this cost is suffered by the investor, and when the structure starts to provide
protection against declines.

Premium. The simplest method of paying for protection is through premium. In this case, a
put or put spread should be bought.

Loss of upside. If the likelihood of extremely high returns is small, or if a premium cannot
be paid, then giving up upside via collars or put spread collars is the best way to pay for
protection.

Potential losses on extreme downside. If an investor is willing to tolerate additional losses

during extreme declines, then a 1×2 put spread can offer a zero cost way of buying
protection against limited declines in the market.

Figure 15. Protection Strategy Comparison

Equity Performance Put Put Spread Collar Put Spread Collar 1×2 Put Spread

Bull markets Loss of premium Loss of premium Loss of upside Loss of upside –
(+10% or more)
Flat markets Loss of premium Loss of premium – – –
(±5%)
Moderate dip Loss of premium Protected – Protected Protected
(c-10%)
Correction Protected Protected Protected Protected Protected
(c-15%)
Bear market Protected Partially protected Protected Partially protected Severe loss
(c-20% or worse)
28 CHAPTER 1: OPTIONS

BEST STRATEGY DETERMINED BY VOLATILITY LEVEL

The level of volatility can determine the most suitable protection strategy an investor needs
to decide how bullish and bearish they are on the equity and volatility markets. If volatility is
low, then puts should be affordable enough to buy without offsetting the cost by selling an
OTM option. For low to moderate levels of volatility, a put spread is likely to give the best
protection that can be easily afforded. As a collar is similar to a short position with limited
volatility exposure, it is most appropriate for a bearish investor during average periods of
volatility (or if an investor does not have a strong view on volatility). Put spreads collars (or
1×2 put spreads) are most appropriate during high levels of volatility (as two options are
sold for every option bought).

MATURITY DRIVEN BY DURATION OF LIKELY DECLINE

The choice of protection strategy is typically driven by an investor’s view on equity and
volatility markets. Similarly the choice of strikes is usually restricted by the premium an
investor can afford. Maturity is potentially the area where there is most choice, and the final
decision will be driven by an investor’s belief in the severity and duration of any decline. If
he wants protection against a sudden crash, a short-dated put is the most appropriate
strategy. However, for a long drawn out bear market, a longer maturity is most appropriate.

Figure 16. Types of DAX Declines (of 10% or more) since 1960
Type Average Decline Decline Range Average Duration Duration Range
Crash 31% 19% to 39% 1 month 0 to 3 months
Correction 14% 10% to 22% 3 months 0 to 1 year
Bear market 44% 23% to 73% 2.5 years 1 to 5 years

Median maturity of protection bought is c4 months

The average choice of protection is c6 months, but this is skewed by a few long-dated
hedges. The median maturity is c4 months. Protection can be bought for maturities of one
week to over a year. Even if an investor has decided how long he needs protection, he can
implement it via one far-dated option or multiple near-dated options. For example, one-year
protection could be via a one-year put or via the purchase of a three-month put every three
months (four puts over the course of a year). The typical cost of ATM puts for different
maturities is given below.

Figure 17. Cost of ATM Put on SX5E

Cost 1 Month 2 Months 3 Months 6 Months 1 Year
Individual premium 2.3% 3.3% 4.0% 5.7% 8.0%
Rolling protection cost per year 27.7% 19.6% 16.0% 11.3% 8.0%
1.5: Protection Strategies Using Options 29

Short-dated puts offer greatest protection but highest cost

If equity markets fall 20% in the first three months of the year and recover to the earlier
level by the end of the year, then a rolling three-month put strategy will have a positive
payout in the first quarter but a one-year put will be worth nothing at expiry. While rolling
near-dated puts will give greater protection than a long-dated put, the cost is higher
(see Figure 17 above).

SHORT VOL AGAINST LONG PUT PERFORMS WELL

All protection strategies that combine a long and a short aim to offset the overpriced cost of
protection by selling the same overpriced implied volatility for a different maturity and
strike. Hence such strategies tend to back-test well as the overall exposure to expensive
implied volatility is near zero. As the net cost of such strategies is near zero, while at the
same time (usually) decreasing the volatility of the portfolio, their risk adjusted performance
can be impressive. Their performance can often be further improved by selling near dated
volatility against the long far dated protection.

MULTIPLE EXPIRY PROTECTION STRATEGIES

Typically, a protection strategy involving multiple options has the same maturity for all of
the options. However, some investors choose a nearer maturity for the options they are
short, as more premium can be earned selling a near-dated option multiple times (as near-
dated options have higher theta). These strategies are most successful when term structure is
inverted, as the volatility for the near-dated option sold is higher. Having a nearer maturity
for the long put option and longer maturity for the short options makes less sense, as this
increases the cost (assuming the nearer-dated put is rolled at expiry).

Calendar collar effectively overlays call overwriting on a long put position

If the maturity of the short call of a collar is closer than the maturity of the long put, then
this is effectively the combination of a long put and call overwriting. For example, the cost
of a three-month put can be recovered by selling one-month calls. This strategy outperforms
in a downturn and also has a lower volatility (see Figure 18 below).
30 CHAPTER 1: OPTIONS

Figure 18. Performance of 3M Put vs 1M Call Overwriting

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SX5E Call overwriting 1m ATM Call overwriting + 3m put

Selling a put against calendar collar creates either a calendar put spread
collar, or a put vs strangle/straddle
If a put is sold against the position of a calendar collar, then the final position depends on
the maturity of the short put. The short put can either have the maturity of the long put
(creating a calendar put spread collar), or the maturity of the short call (creating a put vs
strangle/straddle).

 Calendar put spread collar. If the maturity of the short put is identical to the long (far-
dated) put, then the final position is a calendar put spread collar (i.e. far dated put spread
funded by sale of short dated calls). The performance of a calendar put spread collar is
similar to the calendar collar above.
 Put vs strangle/straddle. If the maturity of the short put is the same as the maturity of
the short near-dated call, then this position funds the long far-dated put by selling near-
dated volatility via a near dated strangle (or straddle if the strikes of the short put and
short call are identical).
Short near dated variance swaps is an alternative to selling near dated
strangle/straddle
For an investor who is able to trade OTC, a similar strategy involves long put and short
near-dated variance swaps.