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The Relationship of the VIX Index and the Monthly Gross Premiums Generated by the BXM Index; Introducing the “Rule of 10” by Matt Moran

by Administrator on 02-15-2012 09:20 AM - last edited on 02-15-2012 09:21 AM

Some investors who are new to options have asked these questions –

  • How can I determine how much premium will be generated by a covered call strategy?
  • Is a high VIX level related to high option premiums?
  • If VIX is at a high level, does that mean that a covered call strategy will perform well?

Many factors can influence the premiums generated by different covered call strategies, and a high VIX level does not guarantee that covered calls will have great performance. (For more general options education, please visit http://www.cboe.com/LearnCenter)

 

The CBOE S&P 500 BuyWrite Index (BXMSM) sells one-month S&P 500 index options at mid-day on the third Friday of every month, while the CBOE Volatility Index® (VIX®) is designed reflect market expectations of 30-day volatility conveyed by S&P 500 stock index option prices.

 

One could use a “Rule of 10” to try gain the following approximation -- if you take the VIX and divide by 10, the resulting number should give you an approximate estimate of the BXM gross monthly premium as a percentage of the S&P 500 Index.  Please see the two charts below for more details.

 

 

 

 

The two charts above used the term “Gross Premiums” because the numbers shown are not net returns.  Please see the table below to see some relationships between VIX levels and the annual percentage change in value of the BXM and S&P 500 indexes.  Note that in 2008, for example, (1) the VIX had its highest average daily closing values, (2) even though the BXM generated relatively high gross premiums that year, the BXM was down 28.8% that year.  The premiums generated by the BXM Index helped the BXM avert the 37% loss endured by the S&P 500 Index in 2008.

 

 

www.cboe.com/benchmarks  www.cboe.com/VIX

 

NEW PAPER BY ASSET CONSULTING GROUP

 

This week the investment advisory firm Asset Consulting Group published a new six –page paper “An Analysis of Index Option Writing for Liquid Enhanced Risk-Adjusted Returns” (available at www.cboe.com/benchmarks).

 

Exhibit 12 of the paper notes that the BXM call premiums sold averaged about 1.8% per month since June 1988.

 

 

Exhibit 13 of the paper notes that “the average value for implied volatility (as represented by VIX) was 20.27 and the average value for realized volatility was 16.38. A number of studies have shown that the implied volatility inherent in index options prices generally has exceeded subsequent realized volatility over multi-year periods (see www.cboe.com/benchmarks). Richly priced index options could provide advantages to

the option seller.”

 

 

Visit www.cboe.com/benchmarks for (1) links to several papers that discuss implied and realized volatility, and (2) more information about risk disclosures (e.g., past performance is not a guarantee of future returns).

 

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About the Author
  • Mr. Bittman is the author of two books, Options for the Stock Investor, (McGraw-Hill, 1996), and Trading Index Options (McGraw-Hill, 1998). He teaches courses for public and institutional investors, and he has presented several custom courses throughout the U.S., Europe, South America and Southeast Asia. In 1980 Mr. Bittman began his trading career as an equity options market maker at the Chicago Board Options Exchange. From 1983 to 1993, he was a Commodity Options Member of the Chicago Board of Trade where he traded options on financial futures and agricultural futures. Mr. Bittman received a BA, magna cum laude, from Amherst College in 1972 and an MBA from Harvard University in 1974. In addition to his responsibilities at The Options Institute, Mr. Bittman is also a member of the faculty of The Illinois Institute of Technology, where he teaches in the masters level Financial Markets and Trading Program.
  • Mr. Kearney began his long association with the CBOE when he became an independent Market Maker in early 1981. Mr. Kearney traded options full time on the trading floor until 1992 and periodically thereafter until 1996. In early 1992 he became a founding partner and Registered Options Principal of a brokerage firm based in Chicago, a member firm of the CBOE. Mr. Kearney’s responsibilities included development and implementation of hedging and trading strategies using listed options for their institutional clients as well as their retail investors. Mr. Kearney is the co-author of Understanding LEAPS®, published by McGraw-Hill, September 2002. He has been a regular contributor to many news services including Reuters, Derivatives Week, BARRON’S, CNBC, Bloomberg, Group W, The CBS Radio Network, FORTUNE, Ticker Magazine, Stock Futures and Options, BBC TV and Radio, NPR, and others. Mr. Kearney served on various committees at the CBOE, including the Arbitration Committee from 1984 to 1996. Prior to joining the CBOE Mr. Kearney was a marketing director for NCR Corporation. Mr. Kearney is a graduate of St. Mary’s University (MN), BS, 1971, and pursued his MBA at Lake Forest Graduate School of Management. In 2006 he completed a 3-year SII/SIA program at the Wharton School of the University of Pennsylvania.
  • Peter B. Lusk is an instructor at the Options Institute, the educational arm of the Chicago Board Options Exchange. He teaches option courses for public and institutional traders and has contributed educational type articles to various financial publications. Peter has spoken to thousands of investors across North America the past few years including over 200 webinars for the CBOE and member firms on trading options. He can also be seen each week on CBOE-TV with his show, Strategy of the Week. In addition to his responsibilities at the Options Institute, Peter serves as an Instructor for the Options Industry Council – an organization representing the options industry in the U.S. Prior to working at the Options Institute, Peter was a highly successful market maker for many years on the floor of the CBOE trading equity options. He was also involved in options training for new market makers at Lakota Trading in Chicago. As a professional trader, Peter enjoys sharing his knowledge of proven option strategies and risk management at the Options Institute.
  • Russell Rhoads, CFA, is an instructor with the Options Institute at the Chicago Board Options Exchange. He joined the Institute in 2008 after a career as an investment analyst and trader with a variety of firms including Highland Capital Management, Caldwell & Orkin Investment Counsel, TradeLink Securities and Millenium Management. He is a financial author and editor having contributed to multiple magazines and edited several books for Wiley publishing. In 2008 he wrote Candlestick Charting For Dummies. Since joining the Options Institute he authored Option Spread Trading: A Comprehensive Guide to Strategies and Tactics which was released in January 2011 and recently finished work on Trading VIX Derivatives: Trading and Hedging Strategies Using VIX Futures, Options, and Exchange Traded Notes which was published in August 2011. In addition to his duties for the CBOE, he instructs a graduate level options course at the University of Illinois – Chicago and acts as an instructor for the Options Industry Council. He is a double graduate of the University of Memphis with a BBA ('92) and an MS ('94) in Finance and also received a Master's Certificate in Financial Engineering from the Illinois Institute of Technology in 2003.
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