represents BXM, worth 6.30 times its initial value as of March2004. Lower line represents SPX, worth 4.20 times its initial value as of March 2004.
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TABLE 12.1 Year-by-Year Profit Comparison
BXM versus SPX
YearEnding
Start1988198919901991199219931994199519961997199819992000200120022003
BXM
100.00108.13135.17140.56174.85195.00222.50232.50281.26324.86411.41489.37592.96636.81567.25523.92625.38
1-YearGain
8.13%25.01%3.99%24.39%11.52%14.10%4.50%20.97%15.50%26.64%18.95%21.17%7.40%–10.92%–7.64%19.37%
SPX
266.69277.72353.40330.22417.09435.71466.45459.27615.93740.74970.431,229.231,469.251,320.281,148.09879.821,111.92
1-YearGain
4.14%27.25%–6.56%26.31%4.46%7.06%–1.54%34.11%20.26%31.01%26.67%19.53%–10.14%–13.04%–23.37%26.38%
Diff
3.99%–2.24%10.55%–1.91%7.06%7.05%6.04%–13.14%–4.76%–4.37%–7.72%1.64%17.54%2.12%15.73%–7.01%
Total Gain 525.38%
316.93%
(Compounded)
Source: Chicago Board Options Exchange
BXM: BuyWrite indexSPX: S&P 500 indexStart: Data from June 1, 1988Diff: BXM One-Year Gain Minus SPX One-Year GainTotal Gain Compounded: From June 1, 1988 to December 31, 2003
periods (15 full years and 1 partial year), but as Table 12.1 shows, in someyears those additional profits were substantial (more than 17.5 percent in2000 and almost 16 percent in 2002). The purpose of adopting a covered callwriting strategy is to improve the probability of outperforming the marketover an extended period of time. As the results show, this anticipated en-hancement was a reality for the period for which data are available. FromJune 1988 through June 2004, BXM returned 525 percent and SPX returned317 percent.
There are going to be years when you may wish you never heard of cov-ered  call  writing.  For  example,  notice  how  the  S&P  index  easily  outper-
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formed the BXM during the very bullish years of 1995 to 1998. But over thelonger term, this strategy is very likely to continue to provide substantialbenefits—reduced volatility and additional profits—when compared withsimply buying and holding a diversified stock portfolio.
Before you decide to rush into adopting an investment approach that du-plicates the BXM strategy, consider some drawbacks. If you want to own abasket  of  stocks  that  attempts  to  mimic  the  performance  of  the  S&P  500index, you must determine the proper number of call options to sell to obtainthe best possible hedge. Here is an example of how to make the calculation:If the current price of the SPX index is $1,100, the formula for the quan-
tity of index options contracts needed to hedge the entire portfolio is:
Amount to be hedged (the current market value of the portfolio) ÷ strike price of the SPX options contract × 100
For example, if the portfolio you construct in an attempt to mimic theperformance of the S&P 500 is worth $250,000, and if you write an SPX op-tion with a strike price of 1100, then to hedge the portfolio properly, youwant to sell
250,000 ÷ (1100 × 100) contracts
That’s  2.27  contracts.  Fractional  contracts  are  not  allowed,  so  youwould write two contracts to provide the best possible hedge. This processhedges $220,000 of your portfolio, leaving the remaining $30,000 unhedged.That’s great when the market rises, but it is not as good when the marketfalls. Fortunately, it’s not necessary to leave yourself exposed to that de-gree of market risk. Although adopting this methodology does allow you tominimize  commissions  (because  the  options  are  cash  settled,  you  don’thave to constantly buy or sell the underlying shares), it’s inconvenient andadds unnecessary risk when you cannot hedge your entire portfolio.
Thus, I recommend that you do not attempt to mimic the returns of theBXM index by adopting the methodology just described. There is a muchsimpler, much more efficient method available to you. The method involvesconstructing a diversified portfolio from among the many optionable ex-change traded funds and then writing covered call options on those shares.Be sure to buy ETFs in increments of 100 shares. To match the returns ofthe BXM most closely, you can write call options that are slightly out of themoney.3 The details are discussed in Part IV.
Although worthwhile to understand how the performance of the BXMindex is calculated, trying to match that index’s performance is not an effi-cient methodology for the vast majority of investors. Stick with a coveredcall writing program in which you can easily hedge your entire portfolio.
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FURTHER EVIDENCE THAT COVEREDCALL WRITING WORKS
The data for BXM presents compelling evidence that covered call writing isa viable strategy. Those who disapprove of writing covered calls argue thatthe  limited  upside  potential  makes  the  strategy  unattractive.  What  thenaysayers fail to mention is that it’s much more common for markets tomake small directional movements rather than to be strongly bullish. It isjust those small movements that produce outstanding results for the strat-egy of covered call writing. It is well worth taking the chance of missing outon part of a huge upward move, because such moves are uncommon. Buteven when those sharp upswings happen, the covered call writer makes outvery well, as the strategy has a bullish bias. In Table 12.1 you can see howmuch better the S&P performed during the bullish run from 1995 to 1998,but the performance of the BXM was pretty impressive also, averaging a re-turn of 20.51 percent (versus 28.01 percent).
There is additional evidence to support the superiority of adopting cov-ered  call  writing.  Richard  Croft,  an  investment  counselor  and  portfoliomanager, and associates have constructed a buy-write index based on theStandard & Poor’s Toronto Stock Exchange 60 index (TSE60). It is namedthe Montreal Exchange Covered Call Writers index (symbol: MCWX). Dataare available beginning in late December 1993.4 The covered call strategyoutperformed the buy-and-hold strategy in 8 of the 10 years of data avail-ability. Table 12.2 shows that while the TSE60 index approximately dou-bled, the covered call index nearly tripled.
The  investment  methodology  used  by  Croft  is  slightly  different  fromthat used by the CBOE and the BXM index. The TSE 60 index portfolio iscomprised of an ETF, the Standard & Poor’s Toronto Stock Exchange 60Index Participation Fund. At expiration, options are cash settled, so it isnever necessary to buy or sell shares of the ETF. The strategy calls for writ-ing a call option that is closest to the money (rather than the first out-of-the-money  option)  at  the  end  of  the  trading  day  (rather  than  early  in  themorning) on the Monday following expiration. Thus, this strategy leaves theinvestor  naked  long  (unhedged)  all  day  Monday  following  expiration.(Croft does not explain why the option trades are not made early Mondaymorning.) These statistics provide additional evidence supporting the ideathat covered call writing enhances portfolio performance.
Not only are returns on an investment enhanced, an additional benefitof the covered call writing strategy is those returns are achieved with a re-duction in volatility. Croft notes that the annual returns achieved by cov-ered call writers are more consistent than those achieved by owners of theETF.5 The CBOE publishes a graph showing the standard deviation of the
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TABLE 12.2 Year-by-Year Profit Comparison
MCWX versus TSE60
Year
19931994199519961997199819992000200120022003
MCWX
102.0105.0119.0156.0191.0193.0231.0269.0268.0247.0287.0
1-YearGain
2.94%13.33%31.09%22.44%1.05%19.69%16.45%–0.37%–7.84%16.19%
TSE60
221.49221.84250.51321.59378.09375.98495.86528.72442.55373.15458.72
10–Year Gain 181.37%(Compounded)
Source: Montreal Stock Exchange
MCWX: Montreal Exchange Covered Call Writers IndexTSE60: the Toronto Stock Exchange 60 IndexDiff: BuyWrite Index minus TSE60
1-YearGain
0.16%12.92%28.37%17.57%–0.56%31.88%6.63%–16.30%–15.68%22.93%
107.11%
Diff
2.780.412.724.871.61–12.209.8215.937.85–6.74
annualized returns is reduced by 33 percent when the buy-write strategy isutilized.6 In layman’s terms, the annual profit (or loss) differs from the av-erage  profit  by  a  smaller  amount  when  the  covered  call  strategy  isadopted—hence, the portfolio value is less volatile.
VOLATILITY INDEX
The CBOE Volatility index (VIX) was originally designed to track the im-plied volatility (IV) of the Standard & Poor’s 100 index (OEX). A changewas  made  in  2003,  and  the  VIX  now  tracks  the  IV  of  the  SPX  (S&P  500index). The methodology used to calculate the value of the index was up-dated at the same time. The calculation includes options with a variety ofstrike prices in the front two expiration months.7 Information is availableonline for those interested in details of the calculation method.8
Originally introduced in 1993 (using data dating back to 1986), the VIXsoon became the benchmark for measuring implied volatility. VIX is a mea-sure  of  future  volatility  expectations,  rather  than  of  actual  historical
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How Implied Volatility Affects Option Prices
High implied volatility (IV) translates into high option prices. For example,consider a call option (stock is 50) with six months until expiration and astrike price of 50:
When the implied volatility is 15, the option trades at $2.35
When the implied volatility is 30, the option trades at $4.40
When the implied volatility is 49 (as in September 2001), the optiontrades at $7.00
When  the  implied  volatility  is  150  (as  in  October  1987),  the  optiontrades at $20.10
It  may  be  difficult  to  believe,  but  the  bid  for  options  that  routinelytrade for less than $3 today were more than $20 for a few days in October1987. And people were desperate to buy those options to protect their re-maining assets. In addition, asking prices were much higher than bid pricesas few people were willing to sell options.
volatility. High implied volatility (high option prices) means there is an ex-pectation that the market is going to be more volatile than usual before op-tions expiration. But the index represents more than that to some tradersand has come to represent a measure of market sentiment, with high VIXmeasurements indicating “fear” and low measurements indicating “com-placency.” That fear represents concern about a large market decline, andhigh VIX readings are considered bearish for the market. The highest read-ings ever recorded occurred during and immediately after the stock mar-ket  crash  of  October  1987,  when  the  VIX  reached  an  incomprehensible150. (For comparison, in mid-2004, the VIX is near 15.) When the marketreopened a few days after the terrorist attacks of September 11, 2001, theVIX reached a level of “only” 49.
Figure 12.2  presents  VIX  data  from  1990  through  year-end  2003.  Thedata in the figure begins in 1988 because the 1987 data (VIX 150 in October)would dwarf all other VIX values.
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VIX (CBOE Volatility Index) 1988 - 2003
xednI
60
50
40
30
20
10
0
01/88
01/90
01/92
01/94
01/96
01/98
01/00
01/02
01/04
Date
FIGURE 12.2 CBOE Volatility Index (VIX), January 1, 1988–June 30, 2004
Source: Chicago Board Options Exchange
WHAT DO ALL THESE DATA MEAN FOR COVERED CALL WRITERS?
You have seen the evidence demonstrating the viability of writing optionsas part of a conservative strategy. The future is unknowable, but:
• BXM data show covered call writers earned a higher return than buy-
and-hold investors over a 16-year period.
• VIX is cyclical and periodically turns higher, then lower. It is difficult topredict when these ups and downs will occur. The BXM data tell us thatit pays to stay with covered call writing during both highs and lows inthe VIX.
• The VIX is currently below its recent range but well above the recordlows. If it eventually turns higher, covered call writing should produceeven better returns than it offers today.
Let’s move on to the specific recommendations of how you can con-struct  a  portfolio  according  to  the  teachings  of  modern  portfolio  theoryand enhance your expected profits by writing covered calls or uncoveredputs.
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PA R T   I V
Putting It All Together
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C H A P T E R   1 3
Building aPortfolio
You know that modern portfolio theory (MPT) stresses the importance
of  owning  a  well-diversified  portfolio.  You’ve  seen  how  exchangetraded funds (ETFs) offer many advantages over traditional mutualfunds for investors who have (or can accumulate) at least several thousanddollars to invest. You’ve learned about options and how they can be used toenhance the returns on your portfolio. It’s time to tie it all together and de-velop an investment methodology that increases the probability of beatingthe market on a consistent basis.
BUILDING A WELL-DIVERSIFIEDPORTFOLIO
The first step is deciding what constitutes a proper portfolio for you. Youdon’t have to be married to that portfolio; you can make changes wheneveryou deem it advisable. To get started, select the types of investments youwant to own. Some sample portfolios follow, but they are merely examples.One may be suitable for you, but the purpose of using examples is to illus-trate how easy it is to compile your own portfolio.
Begin by allocating your assets. This is not an easy task for many in-vestors; they simply invest all their available money in the stock market. Al-though it is not the best way to proceed, if you fall into that category, or ifyou want to invest all your assets in stocks, it’s your money and you are en-titled to make that choice.
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After deciding how much to invest in the stock market, use that moneyto purchase a suitable mix of ETFs. Choose only ETFs that have listed op-tions (see Tables 13.1 and 13.2 at the end of this chapter) and buy in roundlots (increments of 100 shares). You may decide that one broad-based ETFis sufficient diversification, or you may prefer to tweak your portfolio to in-clude several types of ETFs.
You can buy ETFs that invest in domestic or foreign companies. Youcan choose those that invest in small, medium, or large companies. You caninvest in specific sectors of the market. Of course, you can build your port-folio out of any combination of ETFs that suits you.
Keep in mind:
• Trading expenses are important. Each ETF purchase requires the pay-ment of a commission to your broker. Writing options on each ETF re-quires paying another commission. Thus, concentrating your holdingsinto fewer ETFs minimizes expenses. More important, using the ser-vices of a deep-discount broker makes a significant difference in theperformance of your investment portfolio. You don’t ever want to findyourself in a position where you want to make a trade but decide not doso because trading expenses are too high.
• To use options efficiently, you want to own round lots (100-share in-
crements) of each ETF in your portfolio.1
Each sample portfolio assumes an investment of $100,000, but you canmake adjustments to fit your financial condition. It’s easier to see how themethod works when real prices are used, and the prices throughout thischapter were current in mid-2004.
SAMPLE PORTFOLIOS, ASSUMING AN INVESTMENT OF $100,000
Sample Portfolio #1: Based on a Single Broad-Based IndexIfyou want to limit your portfolio to a single ETF and if you are interested inowning  shares  in  the  American  stock  market,  VTI  provides  the  broadestpossible  diversification.  VTI  is  the  symbol  for  the  Vanguard  Total  StockMarket VIPERs. This ETF tries to replicate the performance of the Wilshire5000 index by owning a sampling of the stocks representing that index. Asof year-end 2003, according to the Vanguard Group, VTI represented own-ership in 3,651 different stocks. It’s inefficient for this ETF to own shares ofeach stock in the Wilshire 5000 index because many of those stocks are dif-
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ficult to buy or sell in any reasonable quantity. Because sampling comesvery close to mimicking the performance of the entire index, it’s sufficientto own these 3,600+ different stocks.
VTI  is  priced  at  approximately  $110,  so  buy  900  shares  spending
$99,000.
Sample Portfolio #2: Based on a Different Broad-Based IndexAn alternative investment is the Russell 3000 index, consisting of the 3,000largest publicly listed U.S. companies, representing about 98 percent of thetotal capitalization of the entire U.S. stock market. According to BarclaysGlobal Investors, the ETF owned 2,946 of the 3,000 stocks early in 2004. Thesymbol for the iShares Russell 3000 Index is IWV.
Priced near $65, you can buy 1,500 shares, investing $97,500.
Portfolios Based on Size of Companies
Sample  Portfolio  #3:  Small-Cap  Lover’s  Portfolio Some  in-vestors prefer to own a portfolio consisting of smaller, faster-growing com-panies,  believing  these  stocks  can  provide  better  returns.  During  mostperiods in our history, small-caps have outperformed the stocks of largercompanies, but this has not always been true.
To emphasize small caps, you can add shares of IWM to your portfolio.IWM is the symbol for the iShares Russell 2000 index, which is comprisedof the smallest 2,000 companies in the larger Russell 3000 index. In otherwords, it holds no shares of any of America’s largest 1,000 companies. Ob-viously, the more shares of IWM you add, the more your portfolio empha-sizes smaller capitalization stocks.
One possible portfolio:
Buy 1,000 shares of IWV (price approximately $65; cost $65,000).
Buy 300 shares of IWM (price approximately $117; cost $35,000).
Sample Portfolio #4: Mid-Caps You can build a portfolio consistingof mid-cap stocks by purchasing shares of MDY, the S&P MidCap 400 index,or IJH, the iShares representing the same index. As of this writing, MDY isa better choice because the options are more actively traded.
Buy 900 MDY at $109, investing $98,100.
Sample  Portfolio  #5:  Larger  Companies Diamonds  (DIA),  the ETF representing ownership of the 30 stocks in the Dow Jones Industrial
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Average,  is  a  good  choice  for  an  investor  who  wants  to  concentrate  onowning shares of large, well-known companies.
If you prefer to own an ETF that has more than 30 stocks in its portfo-lio and is better diversified then OEF, the iShares S&P 100 index fund maybe appropriate. This ETF tracks the performance of the Standard & Poor’s100 index (OEX).
Buy 400 DIA at $105, investing $42,000.
Buy 1,000 OEF at $56, investing $ 56,000.
Sample Portfolio #6: Portfolio Avoiding Smaller CompaniesIf you prefer to own a mix of larger and mid-size companies and omit small-capitalization stocks from your portfolio, consider:
Buy 500 MDY at $109, investing $54,500.
Buy 800 OEF at $56, investing $44,800.
Concentrating on Growth Stocks or Value Stocks
When investing in ETFs, you have the choice of buying a balanced portfo-lio or a portfolio emphasizing either growth stocks or value stocks. For ex-ample, several of the iShare ETFs that match the performance of a specificindex also offer ETFs that divide the stocks in the index into a growth sec-tor and a value sector. These ETFs include the Russell 1000, Russell 2000,Russell 3000, S&P MidCap 400 index, and S&P SmallCap 600 index.
Thus, you can buy shares of an ETF representing the entire index, or
just the growth or value portion of the indexes.
Here’s how it works: The stocks in a given index are ranked by theirprice-to-book ratios. To determine the ratio, each stock’s price per share isdivided by its book value.2 This ratio compares how the stock market val-ues the shares of a company compared with the value of the company on itsfinancial statements.
The stock list is then divided into two parts. The stocks with the high-est price-to-book ratios are placed in the growth index and those with thelowest price-to-book ratios are placed in the value index.
The growth and value component indexes based on the Russell indexescontain some duplication of stocks, as the fund managers consider somestocks suitable for both the value and growth portfolios. The growth andvalue  components  of  the  MidCap  400  and  SmallCap  600  indexes  do  nothave any duplication of stocks.
The bottom line is that you have the choice of investing in only part (ap-proximately half) of each of these indexes, if you prefer to emphasize eithergrowth or value stocks.
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Sample Portfolio #7: Emphasizing Growth Stocks
Buy 400 VTI (Wilshire 5000) at $110, investing $44,000.
Buy 200 IJK (MidCap 400 Growth) at $123, investing $24,600.
Buy 300 IJT (SmallCap 600 Growth) at $93, investing $27,900.
Sample Portfolio #8: Emphasizing Value Stocks
Buy 300 DIA at $105, investing $31,500.
Buy 300 IJK (MidCap 400 Value) at $115, investing $34,500.
Buy 300 IJS (SmallCap 600 Value) at $105, investing $31,500.
Note: This  portfolio  is  balanced  between  large-,  mid-  and  small-capitalization stocks and places two-thirds of the capital into value stocks.
Sample Portfolio #9: Includes Investments in Foreign Stocks
It’s not necessary to limit your investments to American companies. Goodasset allocation suggests investing internationally. EFA is an ETF that at-tempts to mimic the performance of the MSCI EAFE index—the MorganStanley Capital International Europe, Australasia, and Far East—the bench-mark  used  in  the  United  States  to  measure  international  equity  perfor-mance.  EFA  invests  in  stocks  from  Europe,  Australia,  Asia,  and  the  FarEast.
Priced near $140, shares of EFA can be added to any portfolio to pro-
vide additional diversification.
Sample portfolio stressing American mid-caps and foreign stocks:
Buy 100 EFA at $140, investing $14,000.
Buy 400 MDY at $109, investing $43,600.
Buy 400 VTI at 109, investing $43,600.
Sample Portfolio #10: Investment in Specific Market Sectors
If  you  are  willing  to  go  against  the  teachings  of  MPT  (this  is  not  recom-mended, but if it suits your investment style, you certainly are allowed tomake this type of investment) and accept the risks and potential rewardsthat come with a less-diversified portfolio, you can apportion some of yourcapital to specific industries. You can do this by owning shares of eithersector SPDRs or HOLDRs.
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If you believe that proper asset allocation includes investing in real es-tate, one path to achieving that goal is to own shares of real estate invest-ment trusts (REITs). You easily can invest in a suitable group of REITs byowning  shares  of  the  iShares  Cohen  &  Steers  Realty  Majors  Index  Fund(ICF).  This  ETF  seeks  investment  results  corresponding  to  the  perfor-mance of large, actively