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.
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.
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.