The Buy-Write Strategy: Effect of Asset Class and Investor Sentiment

Abstract

Existing research focuses on buy-write strategy performance when index options are used as the underlying asset, finding positive excess risk-adjusted returns which are suggestive of option overpricing. My purpose is to extend this literature by conducting a thorough analysis of strategy performance when individual stock options are used instead of index options. Moreover, I examine whether underlying asset class and investor sentiment has an effect on buy-write performance. Using US data from 2008 - 2015, I sort S&P 500 constituents to form portfolios of large, small, growth and value stocks and test for differences in buy-write performance. The returns of each portfolio are then regressed against 2 separate proxies of investor sentiment and several control variables to test the effects of investor sentiment. Contrary to aforementioned buy-write research, I find no evidence of excess risk-adjusted returns, likely due to the implied vs. realised volatility anomaly which is observed in index options but not stock options. Despite existing evidence that options on small and value stocks are expensive relative to large and growth stocks, I find no evidence that firm characteristic has an effect on buy-write performance. This is potentially explained by the relative illiquidity of small and value options resulting in increased trading costs which are not accounted for in previous studies. Consistent with the literature, my results show that in general, investor sentiment has a positive relationship with buy-write returns, especially for small and value stocks. Additional sub-sample analysis shows that during a market downturn the effect of investor sentiment is much stronger, likely due the limited ability of arbitrageurs to exploit mispriced securities. During times of low market volatility the effect of investor sentiment becomes lagged and much weaker in magnitude.