Write on the Money?

An unusual combination of assumptions - markets have frictions, but nonetheless are price efficient - is required to justify the generic buy-write strategy. In theory, a buy-write strategy allows investors to earn the variance risk premium (VRP) when they cannot access the variance swap market because of market frictions. But whether the strategy earns the expected VRP is contingent on markets being efficient. We show that the performance of the generic buy-write strategy that writes at-the-money options deteriorates rapidly in the presence of short-lived anomalies. Empirically, an alternative strategy that is designed to protect against market reversals outperforms the generic strategy. Our analysis provides a potential explanation of why, in practice, these popular option-write strategies earn but a fraction of the expected variance risk premium.