Guest Post: Buy-Write Strategies, Widows, Orphans And 1987
Submitted by Credit Trader
The Buy-Write or covered-call strategy has become increasingly popular and I suspect is dramatically responsible for the "surprising" rally in stocks and compression in vol of the last month or so. The covered write (long underlying stock and selling in-the-money calls against it) supposedly allowing investors to benefit from the enhanced return offered by the option premium.
However, the synthetic equivalent of the position is a short put (think about the payoff profiles) and I wonder just how comfortable these home-gamers would be with the strategy of naked option writing. "Covered Call" just sounds so much better.
Anyway, the point is that while this strategy may be 'ok' for widows and orphans who will never be selling their stocks and are perpetual buy-and-holders. However, to most as the position is working out profitably, the cheap out-of-the-money put that is created will reach a point when it is not worth holding onto any longer (i.e. becomes very rich to the equivalent put or greek speed picks up). This is the point at which the position should be rolled to optimize the income enhancement process.
The issue is that just as during the 1980s and specifically the lead up to 1987, the covered-call creates more positions that need to be liquidated or require more hedging which helps to exaggerate or create selling pressure in any downturn.
The covered-call in fact offers limited protection in a severe sell-off as the hedge is in fact nothing like as linear as many would hope. The synthetic equivalent of the covered-call necessarily puts upward pressure on stock prices and downward pressure on vol - exactly what we have seen in the last few months and saw in 1987.
The charts attached show normalized vol and S&P for the 1987 period and same 2009 period. Look at the similarities! However, the moth of October has been very interesting, we have seen credit markets start to stall, the dollar tanking and TSY yields pick up and at the same time the S&P has burst higher as vol has dropped dramatically.
The regime since the March lows has been of credit leading equities (up and down) and the stalling of the credit rally recently while stocks push divergently higher (and vol lower) has been very conspicuous! A look at the vol term structure (VIX/VXV for a simple example) shows that short-dated vol (the most likely to be used for covered-writes) is exceptionally low (with the term structure steep).
We feel the possibility for a very much self-fulfilling drop in stocks and rise in vol is at hand and the last few days massively schizophrenic behavior is perhaps the first signal that cracks are appearing.