In a Low-Return World, Smart Investors Have Options

Guest Author
June 6, 2023

Cboe Guest Author: Michael Oyster, Chief Investment Officer, Options Solutions

In 1981, the Paul Volcker-led Federal Reserve was in a deathmatch with inflation. Recognizing that the U.S. economy would likely be plunged into recession, Volcker launched the effective federal funds rate to nearly 20% to stamp out inflation once and for all. Bond yields climbed as well. The 10-year U.S. Treasury bond reached its zenith in September 1981, pushing up to just below 16%.

While the impact that the stratospheric rise in rates of the 1970s and early ‘80s had on markets at the time is worth considering, it’s what happened in the four decades that followed that is the subject of our focus here.

In the absence of a declining interest rate environment, stocks may not post returns as strong as they have in recent years, but options-based tools can help make up the shortfall.

A Change in Direction for Yields

10-Year US Treasury Yield

Source: Federal Reserve Bank of St. Louis

Most people today don’t know what it’s like to invest into the teeth of rising interest rates. In fact, the persistent decline in rates from 1981 through 2020 arguably conditioned investors to believe that falling rates are the rule rather than the exception. It’s not.

Overstating the positive impact that declining rates had on both stocks and bonds is difficult. When interest rates go down (as they did almost unabated from 1981-2020), bond prices go up. Period. Regarding stocks, there is an inverse correlation between the price/earnings (P/E) multiple and interest rates. When interest rates go down, the P/E multiple on stocks is free to rise without dangerous overvaluation. This is important because when P/E multiples increase, stock prices almost always rise. By contrast, rising rates place downward pressure on P/E multiples, which in turn can hurt stock prices.

In the absence of perpetually declining interest rates, stocks may post returns in the mid-single digits. Enjoying yearly advances in the teens or higher is a tendency to which many investors have grown accustomed.

In a low-return world, investors will find it more difficult to reach goals. Those with the knowledge of all the tools available to them will have a greater likelihood of success.

History’s Guide to a World Without Falling Rates

In the years that followed World War II, there were peaks and valleys in interest rates, but they trended in an upward trajectory. After peaking in 1981, interest rates then declined for nearly 40 years thereafter. So, let’s compare the long-term performance of stocks in a declining rate environment to that of a rising one.

Rates peaked on September 30, 1981 and bottomed out on March 9, 2020, a time span of about 38-1/2 years. In that amount of time prior to the high point for rates, the S&P 500 Index’s annualized price change (excluding dividends) was 6.5%. The annualized price change over the subsequent 38-1/2 years (when rates were declining) was 8.6%.

Amazingly, if you exclude just the last 13 days prior to the 2020 bottom in rates (COVID bear market), the annualized return during the declining rate environment was 9.6% annualized… far surpassing the 6.5% posted when rates were advancing.

Although no one knows if interest rates will continue to rise, we should not expect the same type of tailwind for stocks from declining rates that existed over the last four decades. In the absence of declining rates, performance from equities may revert to their long-term averages, meaning somewhere in the mid-single digits. If that happens, equity investors will need smarter solutions to enhance returns in order to increase the probability of meeting their goals.

We Have Options

If the stock market of the future posts single-digit gains, options can be particularly effective at making up the shortfall that investors will need to reach their goals.

The Cboe S&P 500 BuyWrite IndexSM (BXM) is a benchmark index designed to track the performance of a hypothetical buy-write strategy on the S&P 500 Index®. In calendar years when the S&P 500 failed to achieve a 10% return or better, the BXM has compared favorably.  

BXM vs. S&P 500

Source: Bloomberg

In calendar years since 1986 when the S&P 500 posted a return that was less than 10%, BXM outperformed it 79% of the time with an average relative performance (including years when the BXM did not outperform) of +4.3% points. Such strong relative performance could prove highly valuable to investors if future stock market performance is muted.

Active Management

The historical outperformance of BXM during lower stock market return years is dramatic, but an actively managed approach could provide even greater returns.

Compared to index options, options on stocks are generally more expensive and some options are exceptionally high priced. Should these be the ones sold to generate income? Not necessarily.

Some stocks are volatile, some are not, and the prices of options affiliated with those stocks are reflected accordingly. What should be sought, however, and can be accessed by an active options manager, are those options that exhibit high ratios of implied volatility vs. realized volatility.

Certain options are consistently priced with the expectation that their underlying stock will exhibit more price volatility than it ends up actually experiencing. Targeting these options for inclusion in a covered call strategy, by selling those that have been consistently overpriced relative to fair value, may compare favorably to both the equity market as a whole (particularly in low stock market return regimes) as well as passive buy-write strategy indexes.

A Benevolent Kind of Leverage

Here’s how options can also be deployed to enhance returns directly. Let’s consider the following structure:

You own 100 shares of SPDR S&P 500 ETF Trust (SPY).

Buy one at-the-money SPY call option that will expire in approximately 12 months.

Sell two Mini-SPX (XSP) call options (with the same expiration date as the call mentioned previously) at the strike price where the option’s price is approximately half that of the purchased at-the-money call.

Why XSP options rather than the directly connected SPY? XSP options are European-style meaning that they can only be exercised at expiration. It is also possible that profits on XSP options could receive favorable tax treatment. While initiating this trade with XSP options requires a margin account, the Securities and Exchange Commission (SEC) recently approved a new rule that could substantially reduce the margin required for a “protected option.” which includes selling index options against shares of an Exchange Traded Fund (ETF) based on the same index as the index option.[1] This new rule, when fully implemented by brokers, could present a new and interesting way to use XSP and other index options.

Suppose that the sold calls’ strike price is 8% above the current value of the SPY. Then let’s say that over the course of the 12-month period until the options expire, SPY advances 7%, which is a realistic return in the absence of declining interest rates. In this case, the investor will double the return of the market and earn 14%.

How? Is this some form of leverage? Yes, but a far more benevolent variety than the variety with which many of us are familiar.

In investing, leverage is frequently known as the excess ownership of something as the result of borrowing more of it. In deploying such leverage, an investor can earn more if the asset increases in value while risk losing more if the asset’s value declines.

In the options-based structure above, the leverage is applied solely to the profit side of the equation. An investor who deployed it would lose no more than the SPY on market declines and unlike many levered investments, cannot lose more than their initial investment. The cost is the opportunity to earn more than 14%.

For given returns of SPY at options expiration, the following shows the payoff of the options-based structure with 2x return of SPY up to 8% and one-for-one downside participation:

[1] Please see SEC Release No. 34-97019; File No. SR-CBOE-2022-058 

Source: Options Solutions


A studious investment researcher who analyzed nearly any long-term period of recent stock market performance may conclude that the US stock market should be expected to return between 12% and 15%. Absent from that analysis, however, is the fact that the period in question coincided with a historic decline in interest rates. That cascade in rates provided unprecedented support for stock market performance. Going forward, absent that tailwind, expectations for stock returns should be reduced.

Options offer the astute investor the opportunity to contour the risk and return outcomes of their stock market experience to something more attune to their needs – risk reduction, enhanced return, or a combination of both. Investors who draw upon such tools in coming years may provide themselves with a greater probability of attaining their performance goals.

This article is part of Cboe’s Guest Author Series, where firms and individuals share their insights, strategies and ideas with the broader Cboe community. Interested in contributing? Email [email protected] or contact your Cboe representative to learn more.

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