We have not spent a great deal of time here at Abnormal Returns discussing the options markets. (However we did delve into the concept of “stock replacement strategies” in a previous post.) This is due in part to the fact that there are a number of blogs like the Daily Options Report and VIX and More that already do a good job of focusing on the options markets.

As options trading has become less costly it has become more popular we have seen a rise in options volume and the growth of options-focused brokerages, like optionsXpress. Even more interesting from a portfolio management and asset allocation perspective has been the growth in options-related strategies as an asset class.

There already is a thriving sub-section of the closed-end fund world devoted to buy-write equity funds. For additional insight one can check out Random Roger’s work on the subject. Now the buy-write theme has crossed into the ETF world or more specifically the ETN world with the iPath CBOE S&P 500 BuyWrite Index ETN (BWV). See this post by IndexUniverse.com on this new fund.

Now the CBOE has launched a new index focused on cash-collateralized put writing. Heather Bell at IndexUniverse.com delves deeper into the nature and performance of the new CBOE PutWrite S&P 500 Index. This strategy will inevitably be compared to that of the buy-write index. In theory the performance should be comparable. The payoff from a long stock-short call position is identical to that of a short put position, holding leverage constant.

The focus to-date has been on options writing strategies. There is a very good reason for this.  Historically index options have been overpriced.  CXO Advisory Group reviewed a recent paper that explores this very topic. In the paper researchers find that put-writing strategies demonstrated abnormal returns even after transaction costs. However these strategies came with occasional periods of severe drawdowns.

As an self-directed trader there is a large range of customized options strategies one can follow. However an asset class-focused investor is more constrained. Options-related funds may very well have a place in your portfolio.

One needs to be fully educated on the nature of a fund’s strategy and source of returns. Absent a continuation of index options mis-pricing the high yields on these funds need to come from somewhere. That somewhere comes from selling away the right to a good chunk of the market’s return distribution.  If that concept is not clear, then take a step back and learn a little more before investing.