Covered call writing (also known as buy-writing) was, is and will likely always be the most popular use of options.

It a simple and effective strategy. Own stock? Sell an equal number of calls against it. Worst case is best case, in that if the stock rallies and the calls you shorted close in the money, you get assigned the stock. You have now sold your stock for a profit.

Or if the stock you already own declines, the calls you sold at least provide a modest cushion to the loss.

Over the course of time, this strategy provides near-market returns with reduced volatility.

The Wall Street Journal recently ran an in-depth piece on the subject, and Mark Wolfinger of Options for Rookies had a bevy of thoughts on the subject as well, most of which I agree with. I’d like to add a few of my own, though.

Benefits and Drawbacks of Covered Calls

Covered call writing is an excellent strategy when viewed as an alternative to simply owning stock. The obvious benefit of a buy-write is that it cushions losses in a decline, whereas the obvious drawback is that it limits upside.

If you sell at-the-money (ATM) calls on a stock and the stock explodes, all you gain is the premium on the calls you sold as your stock gets called away.

I ran all sorts of number for my book, Options Volatility Trading: Strategies for Profiting From Market Swings, and found the underperformance issues were not as severe as one would expect. Even in strong bull moves, the rallies are often short bursts, so a buy-write strategy of selling near-month, or relatively near-month calls, and rolling the position (buying them back and shorting the next cycle out) tends to only underperform in short stretches.

When to Use a Buy-Write

You might think that the best time to use this strategy would be when we’re seeing the CBOE Volatility Index (VIX) at elevated levels, because higher call premiums would mean better returns. But it’s often counterintuitive when viewed on a relative basis.

Here is a graph of CBOE S&P 500 BuyWrite Index (BXM) versus the SPDR S&P 500 (SPY) for 2009. The more BXM outperforms SPY, the better this graph looks.

So when did this strategy of using a buy-write in a high-VIX environment fare the worst for investors last year?

From early March to early May. In early March, the VIX was 52, and by early May it had declined to 35.

Put another way, buy-writing with the VIX high was a very poor decision, on a relative basis. Sure you made nice money, about 20% in two month’s time, but you just left plenty on the table as SPY lifted 34%.

Contrast that with the last quarter of the year. The VIX spent most of it’s time hovering in the low 20s, yet BXM actually modestly outperformed the SPY.

In other words, buy-writing with the VIX over 50? Poor asset allocation. Buy-writing with a VIX less than half that level? Just fine.

Now I know what you’re thinking as you see that chart. Doesn’t the early part of 2009 look like the best time of all to buy-write. Yes it was, on a relative basis. But remember, that’s when the market was imploding, so “outperformance” simply meant doing “less bad.” If that was your actual goal, being in cash clearly trumped buy-writing.

If I have a grand point here, it’s that buy-writing (or naked put selling, which is effectively the same thing) is an excellent strategy over time. Even, and perhaps especially, when the VIX seems low.

If you need more convincing, just look at that graph again. The market rallied roughly 20% last year, and when all was said and done, BXM did too.