Profiting from Risk Aversion 19 comments
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In October and November of 2008, we have seen the equity and bond markets descend into a state of extreme risk aversion. Investors need look no further than the VIX index to see this. VIX is often referred to as the “fear index” because it goes up when investors drive the prices of options upwards in an attempt to buy some protection for their portfolios (pdf). VIX has been closing in the 70 to 80 range for weeks—albeit with periods of lower volatility in between. VIX actually measures the implied volatility of options on the S&P 500 index that are very close to expiration—think near term---30 days or so. While many investors are focusing on the short-term swings, there is a great deal of information available by looking at longer time horizons (i.e. longer dated options). There are also substantial opportunities to manage portfolio risk for the investor willing to pay attention to the levels of implied market risk in options.
After analyzing the broad market conditions, I find that selling covered call options into this market looks attractive—but not selling covered calls on just anything. As investors have become highly risk averse, they have driven the prices of options so high that even some very stable stocks have ended up with options prices that seem excessively high. Investors can sell covered calls on these stocks, thereby realizing a considerable portion of the upside potential and providing a cushion against potential declines in price.
Looking At Volatility
Aside from VIX, we can get considerable insight by looking at the implied volatility in individual stocks relative to the S&P 500. It is also useful to look at longer-dated options—those with expiration dates further into the future. Implied volatility is the volatility that must be assumed in order to get options prices to reconcile with the price of the underlying security and the length of time until an option expires. As of November 24, 2008, the implied volatility for at-the-money options on SPY with expiration in December 2009 is 45%. At-the-money means that the strike price for the options is very close to the price of the underlying (the S&P 500 index).
A useful calculator to retrieve options prices is provided at iVolatility.com. At-the-money options for the S&P 500 (SPY) with Dec 2008 expiration have implied volatility of 68%. In other words, the options market is predicting that the volatility of the S&P 500 will drop dramatically over the next year or so. That said, an annual average volatility of 45% is three times the long-term historical average volatility for the S&P 500. Still, volatility could easily drop to 15% over the next year or so from current levels to yield an annual average of 45%. If volatility on the S&P 500 dropped in a linear trend from 68% to 15% from Dec 2008 to Dec 2009, you would average 45% (See chart below).
click to enlarge
Let’s imagine that we are willing to accept the current market outlook on volatility from the options prices on the S&P 500: implied volatility of 45% for December 2009 options. If volatility is very high and the market is implying a big drop over the next year, there is a very obvious strategy for investors: sell covered call options. I am discussing selling covered calls, but one might sell put options, too. The problem with selling puts is that you will either have to sell covered puts (which means being short the underlying index) or you will have to post margin and be subject to margin calls. I am going to focus on writing covered calls.
If the options market is correct that volatility is going to fall considerably over the next year or so, isn’t this already priced into the options? In other words, you will get less money for selling your call options simply because the market expects this big drop in volatility. The simple answer is that it makes sense to look at the prices of options in terms of the component of future return that can be locked in by selling options. When implied volatility is low, you are selling off the upside potential of your holdings rather cheaply when you sell covered calls. When implied volatility is high, you are selling off the upside potential at a premium price—you get a lot more money (the option premium) in exchange for the potential price appreciation in the stock.
An added source of value is the following. Volatility on the S&P 500 must relate in some way to volatility on individual stocks. I have adjusted the baseline volatility for the S&P 500 in Quantext Portfolio Planner (QPP) to match the options on SPY (45% annualized volatility) and then used QPP to calculate the volatility of a wide range of individual stocks. The results suggest that the market is not consistently pricing volatility on individual stocks, given the implied volatility of the total market. In other words, the options prices suggest that investors have become indiscriminately risk averse, driving up options prices on even very benign sectors.
Examples
Let’s look at some examples. The table below shows implied volatility for options on SPY, as well as for a series of stocks, using options prices through November 21 from iVolatility.com. The table also shows QPP’s projected volatilities for these stocks, given an adjustment to QPP so that the projected volatility for the S&P 500 matches the options on SPY expiring in Dec 2009.
This list of stocks is not a random choice. These are stocks for which we have found major disagreement between the options markets and QPP’s estimates of future volatility. In particular, these are stocks for which QPP projects much lower volatility than the options market does. This is important because the implied volatility determines the prices of options. If QPP is correct, an investor selling covered calls on these stocks will receive a higher price for the options than they are really worth. Put another way: QPP suggests that selling covered calls on these individual stocks will provide an attractive risk adjusted return.
The big question, of course, is whether we want to trust QPP’s estimates of the relative risks associated with these stocks. We can motivate the answer quite simply. Look, for example, at Procter & Gamble (PG). The implied volatility for PG suggests that this stock has the same volatility (i.e. risk) as the S&P 500. Does this make sense? First, let’s look at how PG has handled the big bear market in 2008:
Does it make sense to believe that PG is as risky as owning the S&P 500? Certainly the conventional wisdom is that owning more stocks (as in the index) is less risky because you have spread your bets. QPP suggests, however, that PG is substantially less risky than the S&P 500 on a going forward basis. Further, given PG’s underlying business, it would seem that PG is a pretty good bet for getting through economic downturns.
Let’s look at some of the other cases from the table above:
I have found similar narratives for a range of stocks (see the table above), which QPP suggests will be substantially less volatile relative to the broader market than their options prices suggest.
Let’s set aside QPP’s assessment of the over-valuation of the call options and just look at the prices of representative call options on these stocks:
These options prices and prices for the underlying stocks came off of eTrade on November 24. I chose options with strike prices that allow the seller of covered call options to retain some of the upside potential before having the stock called away. From my perspective, these options quotes themselves suggest that the options are substantially over-priced, even without looking at QPP. Let’s look at PG again. We can sell a covered call on PG with a strike of $70 and receive $6.70 in premium. This is an immediate 10.6% return on the net position in PG ($6.70/$63). On top of this, we will receive the dividends (2.5%). January 2010 options expire on the 15th of January in 2010—which is 1.14 years from now. We have thus “monetized” annual return of 11.8% for PG. This return ignores the impact of changes in underlying stock price. If the stock price declines, the total return will be the sum of 11.8% and the decline. If the stock price increases, the total return will be the sum of 11.8% and the price increase up to $70 for PG, at which point there is no additional return (because the option will be exercised). In other words, there is substantial retained upside potential, in addition to a “monetized” return that is substantial for what is considered a conservative stock.
Discussion
It is encouraging that the options on SPY imply a substantial decrease in volatility between now and the end of 2009. In the interim, however, the extreme volatility we have been seeing has pushed the prices of options so high that selling covered call options against certain holdings appears to provide an unusual level of profit potential. Selling covered calls on the right stocks at the current levels “locks in” or “monetizes” a substantial portion of the future return potential, and the payment received from selling these options will cushion further declines if they should occur.
At the current market levels, the prices of options suggest a future that is very risk averse. The implied volatility for JNJ, for example, is 38% for the Jan 2010 options. Let’s estimate the expected return for JNJ at 8% per year. At the current level of implied volatility, there is a 2.5% chance that JNJ will drop by 68% over the next year. In the last twenty-two years (chosen to include the crash of 1987), the most that JNJ has dropped in a single year is about 24%. Selling the covered calls is partly a bet against volatility—and particularly the level of volatility that we see in this market.
Companies like Johnson and Johnson (JNJ), Procter and Gamble (PG), Southern Company (SO) and others in our list are simply not as exposed to the forces that have driven volatility up so dramatically in the broader markets. These stocks tend to be more concentrated in what are called “defensive” sectors like utilities. The large degree of decoupling between the earnings risk of these companies and the broader market leads to QPP’s projections that their volatility levels will not increase in lock step with the S&P 500. This does not mean, however, that all stocks in a given sector will exhibit these qualities. I am using Quantext Portfolio Planner’s volatility projections as the initial screen to identify promising candidates. Even without QPP, there is a common sense element here. I can “monetize” a substantial portion of the potential future returns from a range of stocks, even without considering the potential market over-estimate of future volatility.
I plan to revisit this analysis in the future to see how the strategy has performed. I expect that this approach will out-perform, largely driven by the extremely high implied volatility on a range of conservative asset classes. This opportunity is one that does not come along all that often—only when investors seem gripped by extreme risk aversion.
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This article has 19 comments:
AS always, and extremely well written article with good analysis, theoretical explanation, and practical advice. Thank you.
It has been shown mathematically that trading with options in the long run, when all things are appropriately considered, including transaction costs, is basically a zero sum game. (You may do great selling calls this quarter, but next quarter you may lose your shirt.)
It is also true that flipping coins in the long run is a zero sum game. That's not to say that you can't make money flipping coins. You certainly can. But you can also lose money. In the long run, if your goal is to make money consistently, then you are wasting your time flipping coins and playing options.
Your comments suggest that you have not understood my core premise. I am not one of those people who believes that simply buying stocks and selling covered calls will generate a higher risk adjusted return. To the contrary--in most market conditions, all selling covered calls will acheive is to lower the return of the portfolio, as well as lowering the downside due to premium received. In this market--an extremely risk averse market--it can make sense. Think of it this way. Lets say I ask you to sell me a call option on your holdings. At some price, you would be willing to consider it--not matter how aggressive an investor you are--because I will be offering more than the upside on your stocks is worth. When market volatility is really high and investors become indiscriminately risk averse, they may offer a lot for that upside.
Option valuation can be theretically complex, but it is ultimately just a matter or valuing the probability distribution in returns beyond the strike price. Even with a fat tailed distribution, you can model that upside somehow.
* You're Kidding you'd be correct if prices of options were reflecting the real volatility of the stocks, but it seems they are overstating the volatily of some stocks
seekingalpha.com/artic...
This post shows volatility over the history of the S&P500 and shows that short-term volatility has never been this high. When things hit extremes like this, it is most often a good time to bet Reversion to th Mean (RTM). My point goes even further. Even if you accept that this level of vol is rational for the S&P500, it still seems too high for some low correlation sectors...
You're about one of three SA authors I read at this point. On behalf of quants everywhere, thank you.
the point is this --- in today's world, the black-shoels model of option pricing isn't the best. there are quants out there doing regression analysis. for example, i have run neural network quarterly fundamental stock market analysis to predict stock price in recessionary and non-recessionary environments... according to your numbers and the 20% gains you're locking in, you're a god. I think that there's more upside than 20% by owning the stock. I'd be the one taking your bet and buying your call. Maybe I'm the idiot.
oh well, it's definately weird that 2 stocks you covered had representatives come and talk recessionary marketing to me today. GE and gnip(a startup---huge potential!) came too. best of luck.
First off, the implied vol is sort of a beast unto itself--a reference point. QPP and other tools use different models but by any measure, the price of call options on a range of stocks already captures much of the upside potential. If you expect 8% return on a stock like PG and you can "monetize" 12% and still keep another 10% of potential gain, that is pretty amazing when you think about it. You may be right that there is more upside, but my approach is to be like the house and your approach is to be the gambler---I am betting the odds across a bunch of positions. If I can monetize 12% on a stock with an expected return of 85 and lower risk, I am going to do this--it may not be exciting, but it all depends on your risk tolerance. The market is certainly betting on a lot of upside potential--thats why the options are so expensive--and that is why it is a good time to let the market take its bets.
Your approach to this strategy would be a more aggressive way to play this, but it could certainly work...the challenge is managing your margin. Bigger players can easily do risk netting..and that makes inst. approaches to this much more efficient.
I have a couple of comments:
1) Options are sort of theoretically a 100% zero sum game. Arguing that no money can be made on them is the equivalent of saying there are no return to stocks. The law of put-call parity gives:
+(long)Call -(short)Put + (strike/rfr for time x) = long stock.
So, a long stock position is derived from being long the call and short the put and what you can get by putting the rest of the money at the RFR. So short call, long put is synthetically the same as being short. If this was not true beyond transaction costs, it would give rise to arbitrage opportunitites. It is a zero sum game only in the sense that someone has essentially swapped with you the future value of the underlying security which is really not extraordinarily different than someone simply selling the security, sitting on cash instead and banging their head on a wall when the security goes up in value. Except in this case, if they didn't hedge their exposure to you they truly are a loser in the transaction. But many options positions are taken to hedge exposures in the first place and thus are very useful even if/when they are the loser. In the case of option dealers, they are of course hedging their underlying exposures and making their money from spreads rather than bets.
What put-call parity would suggest to me, is that if there is an underlying trend to the position (say upwards), you are likely to gain some amount of your gain from owning the call and some amount from selling the put and of course the reverse is true if the trend is down.
If we are going to claim there is no trends anywhere and that market volatility determines everything, then I suggest you look at a graph of the S&P 500 over the last 100 years. Or banks in the last one and a half. Citigroup volatility in 2007 did not predict it could come anywhere near $3/share within the next year. I am not claiming one should follow trends, the much harder thing is to identify them and understand why they will continue or break down. Sometimes the easiest thing is to simply understand why they will reverse and to prepare for the reversal. But to argue they don't exist is to put your head in the sand. The long term trend of money supply and earnings power from that money supply, is up.
In fact, I like to think about this when making any of my own positions, because the option positions are actually the components that derive the long or short position. Do I like selling the put? Do I like buying the call? Sometimes a desire to go long will suddenly find a disagreement emotionally at the idea of being short the put and realizing that I only like the call, but in fact I also may not like the price of the call, since it has to be supplmented by selling the put I don't feel comfortable selling. It has helped keep me out of trouble on occasion.
Option valuation can be theretically complex, but it is ultimately just a matter or valuing the probability distribution in returns beyond the strike price. Even with a fat tailed distribution, you can model that upside somehow.
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Sure, you can model it somehow. The problem is, "somehow" is a "model," and that model is based on a technical evaluation of whatever you see as a value indicator for future performance. This "feeling" that you have that you may be correct, is an emotional reaction that may, or may not be indicative of the future. If you're lucky, you make money. If you are unlucky, you lose money. But if you are lucky, it doesn't prove that your analysis has been correct or that your method will go on to win again. To know you have a solid technique that really works requires mathematical proof, and the human behavior that determines market prices in the future (buying and selling) cannot be predicated mathematically.
So whittle away with your technicals. But sorry, none have yet been proven to be better than random chance in the long run.
A better way is to focus on the long term. Everybody knows we will eventually get out of this mess. Maybe it will be 2 or 3yrs, maybe 5 or 6yrs, maybe 10yrs or more. Looking down the line and becoming as aware as possible of the macro economic forces of slow waves that are moving through the economy right now, like: increasing unemployment, increasing deficits, increasing bankruptcies, decreasing consumer spending, decreasing liquidity, decreasing confidence, etc., all say its going to be awhile before these trends turn around and the economy starts growing again. So a good bet if you want to go long is buy and hold for the long term. Or, maybe the reverse in inverse index ETFs for the short to medium term, although that's more risky. Beyond this kind of generality, like trying to predict the short term with technicals, is likely to prove a dangerous waste of time.
On a number of points, we agree. A long view makes most people better investors. On the other hand, there is considerable evidence that a long view of investing can be enhanced with fundamentals. Investing at low P/E ratios leads to higher long-term returns. Why? Reversion to The Mean (RTM). You sound like you would subscribe to a lot of Bogle's tenets--and RTM is a core theme of his. Selling select covered calls as I discuss in this article is simply another form of RTM--betting that extreme volatility will settle back towards the mean. The math can get a bit esoteric, but thats really all thats going on. Similarly, I wrote for years before 2008 that volatility was likely to revert upwards--again RTM. RTM is one of the most conservative things to bet on in the long-term--whether you are looking at the equity risk premium, P/E ratios, or volatility.
Yes, being net long the call (whether you are long the stock or just the call) allows you to grow when the broader economy makes money. You don't need to believe that there are no trends--i.e. that the market is a pure random walk to make my case here. BUT, when market volatility becomes irrationally high, I will believe that the call value exceeds the true growth potential for certain stocks---THAT is my whole point. This does not detract or even bear on put-call parity. The long-term expected return for the S&P500 is positive over the long-term---but the implied vol is SO high on some stocks that this is priced in.
Sorry Geoff, my comments were actually a little more pointed towards other comments on the board. My comment was basically to point out the idea, that if there is no way to make money in options, there is also no way to make money in stocks either. A pure random walk making options impossible to make money at indicates that there is in fact zero return to stocks as well. It wasn't really meant to be a trends mantra or anything to slight your idea. I certainly am not one to claim that all prices are equal at all times. I think it's an insightful thing you've picked up on. But what I will add, is that a real trend may skew what volatility says the range of outcomes theoretically should be and what may actually happen. If the return comes on average from both being long the call and short the put, a real trend may skew where the return is coming from one that you expect "shorting the put" to one that you do not expect "long the call", because that excess volatility you are noting may be a signal of change to come, not just a volatility anomoly to be taken advantage of by selling vol.
I remember seeing some study a while back from some investment bank about running a covered call strategy. What was interesting is that the study said you should not sell the call under volatility extremes and that history shows you do better by just retaining the long position temporarily. What that would indicate is that under those extremes, you get more return on average from owning the call, than from selling the put.
You wrote: "Thoughts on Market Volatility". So you've already laid out exactly what I'm talking about in many ways.
On Nov 28 06:30 PM Geoff Considine wrote:
> To Greg Harris:
>
> Yes, being net long the call (whether you are long the stock or just
> the call) allows you to grow when the broader economy makes money.
> You don't need to believe that there are no trends--i.e. that the
> market is a pure random walk to make my case here. BUT, when market
> volatility becomes irrationally high, I will believe that the call
> value exceeds the true growth potential for certain stocks---THAT
> is my whole point. This does not detract or even bear on put-call
> parity. The long-term expected return for the S&P500 is positive
> over the long-term---but the implied vol is SO high on some stocks
> that this is priced in.
Selling options that are not covered is, in general, riskier than selling covered positions. If you keep enough cash handy in your account, you can avoid margin calls as you say, but that has a cost too. Perhaps I misunderstood your point?
www.reuters.com/articl...