As I discussed briefly on a new podcast this week, volatility trading is unique because it attracts some of the smartest people in finance as well as some of the dumbest. Vol trading attracts smart people because it's fertile ground for the use of applied math to squeeze arbitrage or near-arbitrage profits out of the financial markets. It attracts dumb people because you can make a bunch of quick money underwriting infrequent but dangerous risks and look like a trading genius for 5-10 years before you blow up your fund (see the now-defunct XIV ETF for a recent, real-world example).
Without regulation, this is precisely what would happen with insurers of hurricanes, earthquakes, and other occasional but inevitable natural disasters. However, like the business of insurance, volatility trading presents unique opportunities to profit if you can manage risk.
One reason to include volatility trading in your portfolio is to earn a risk premium that isn't strongly correlated with corporate earnings/GDP growth over the long run.
This is a great thing to be able to do if you're managing a portfolio. Selling crash insurance on stocks is not the same thing as owning the upside, which means in many scenarios, engaging in both volatility selling and owning stocks at the same time can make returns more predictable than doing either in isolation. Here's a graph that illustrates this point.
Source: Advisor Perspectives
As you can see, volatility strategies are not highly correlated with equity valuations, and this case is further strengthened when the portfolio is hedged against equity risk, as you can see in the second graph.
The volatility risk premium is the tendency of implied volatility to exceed realized volatility, which drops into put sellers' pockets, even if they maintain a roughly market-neutral portfolio with respect to equities. Of course, if the market goes down 20 percent in a day as it did in 1987, your loss exposure is the loss on your gross position size minus your hedge and premium (typically around 10-12 percent of your gross exposure for delta-neutral trades), but in scenarios where stocks go sideways for years and years, volatility selling is an excellent diversifier.
Why does this work?
Some market observers think that volatility selling has become a crowded trade that's due for a beatdown. This may have been true in 2017 when XIV became the hot trade of the year and a bunch of banks sold similar swaps to yield-hungry investors, leading to poor returns for short volatility in 2018 when overly ambitious underwriters like the XIV fund were blown out of the market. Since then, however, one would expect that with the weak hands gone, returns should be in line or even above what we've seen historically. This is what you tend to see in other insurance markets, such as hurricane insurance on the East Coast of the US. Additionally, like businesses trying to purchase insurance during hurricane season, buyers pay through the nose if they even can find someone to sell them insurance when markets experience sharp increases in volatility.
What I have found in analyzing options data is that sellers of volatility often are misallocating capital and selling into areas where there is poor demand.
This is consistent with the fad of commodity investment by institutional investors in the 2000s and early 2010s, where many investors severely misallocated capital under the idea that they were earning a long-term risk premium.
As such, it's worth analyzing the components of supply and demand for options. I pulled up a couple of papers that analyze the supply and demand for options to help understand why the opportunity exists, and if it will continue to do so in the future. First is a paper by the University of Southern California and the National Bureau for Economic Research. Second, here's one done by the University of Chicago, also working with the National Bureau for Economic Research.
The key findings from both papers are that households, hedge funds, and other institutional investors like pension funds are net-long put options, meaning they buy more than they sell. Market makers, proprietary trading firms, and broker-dealers are typically net-short put options and supply the first group of investors. This market structure contrasts with the idea that "everyone is doing it" when it comes to volatility selling. Note that the institutional investors buying puts aren't always idiots, as the same group of research finds that when put demand is unusually high, stock returns tend to be poor. The subsequent put returns aren't good enough to beat the sellers, however, as the sellers still earn a volatility premium at the expense of the buyers in choppy market environments and typically are able to hedge the equity component away.
Also, to understand why this opportunity may exist, consider investor biases and constraints – if, for example, you were a recently divorced hedge fund manager going into the fourth quarter with an expected year-end bonus of $20 million, buying puts is a way to help ensure that you end the year on a good note, even if they are somewhat overpriced. Holding onto your positions without protection means you might not get paid any bonus at all if the market heads south. This is a made-up example but is indicative of how bias, constraints, and conflicts of interest can fuel institutional investors to purchase insurance. Economists would say that such a manager would be sacrificing some of the expected value of his portfolio for "utility."
Supply and demand matter for selling options. The most attractive ones to sell are the ones that everyone else wants to buy. I covered the dynamics of optimal strike and calendar selection more in my last options article for those interested. This means that when most investors like to put out of the money puts and sell out of the money calls, you need to do the opposite, particularly on the put side. Through the magic of put-call parity, for any given strike, selling puts and writing covered calls should get you roughly the same result. However, if you asked a group of retail investors selling covered calls whether they would entertain selling puts, chances are they would think you were crazy!
Whether you choose to do covered calls or sell puts, research shows that selling options below the strike of the stock get the best return per unit of risk.
The vast majority of investors use call/put options to speculate on the direction of the market, but the consistent money is made betting on the volatility. Also, sellers structurally are able to demand a premium for writing options since options expose them to the risk that markets move faster than they can hedge, whereas buyers get to offload this risk on someone else.
How to sell volatility using options
There are several ETFs that sell puts, but none of them are run to take advantage of the theory that makes smart put sellers money (hedging, strike selection, etc).
Thankfully, the cash-settled SPX options on the S&P 500 index are the biggest marketplace for volatility trading in the world– and also get special tax treatment (60 percent long-term gains regardless of holding period). The options you want to trade are the PM settled monthly options which expire the day after the classic ones. The AM expiration options are old-school but expose investors to unintended risk because they stop trading on Thursday but settle Friday morning, and I view them as possibly manipulable. This gives a clear advantage to the PM settled options, which can be traded up to their expiration and typically have more liquidity (in terms of the bid/ask spread size) for the brief periods I've looked at.
The main downside to SPX options is that each contract is 300k notional, meaning you need at a minimum, 100k in capital to play ball. ETF (SPY) options can accommodate smaller traders, however, as each contract is only 30k.
For other indexes, such as the Nasdaq, the ETF (QQQ) options are much more liquid. I covered QQQ covered calls in my last options article for those interested, the article also covers some of the theory behind the trades. Also, note that the IRS is not clear on whether ETF options get tax benefits or not, it seems that one could reasonably take the position that they qualify for better tax treatment based on tax law, but that's a CPA's domain and not mine.
Anyway, to sell volatility, all you have to do is sell out of the money puts (or covered calls, but the strategy works far better with in-the-money calls). Note that you're getting two risk premiums here, and thus two risk exposures. The first is the volatility premium, and the second is the equity risk premium. Selling an at the money put gives you 0.5 delta to the market, meaning you're effectively 50 percent long the index. This number then fluctuates depending on whether stocks go up or down. To get delta neutral, options traders have software that tells them how much delta they have so they can reset their exposure. To do this, you periodically buy and sell stock to offset the options position. This is known as hedging.
If you constantly adjust your position to be delta neutral, then you cancel out around 95 percent of the equity market risk (Beta) and only take the volatility risk. If the market crashes, they both get hit hard, but the volatility risk premium can make you money if stocks go sideways or even down over time. This may sound complicated but every online broker I've had has had software to handle the calculations for delta in real-time.
Why not just take the equity market risk?
Some of you likely will read this and say, why wouldn't I want to take the market risk and earn the risk premium? The answer is that I do want to take the equity risk, but I want to take a predefined amount of risk and don't want to let market fluctuations decide how much risk I take. During a normal environment, my trading model should usually be set to have around 60 percent exposure to the market. If I want to take an additional 30 percent gross exposure in delta neutral put selling, this allows me to keep my 60 percent exposure constant and hedge the rest of the equity risk to pocket the volatility premium.
With the trading strategy I developed (optimizing strike, expiration, position size, volatility mean-reversion forecast), I expect to profit roughly 150 basis points per year on the portfolio level from the strategy in exchange for increasing my stress test (1987 crash) losses by a little less than 5 percent. As such, you'd need to see a 20 percent market crash every 3-4 years for the strategy to no longer make sense. Volatility trading, in this case, gives a small but real boost to trading profits and can smooth out some fluctuations in equity prices and interest rates.
Total positions (credit, equity, commodity, interest rate futures, etc.) will typically add up to a little more than 2x the capital in the portfolio, so the idea behind being delta-neutral with the volatility strategy is to not take unintended risks. When volatility conditions are high, the model calls for reducing long positions in equities but holding volatility exposure steady and even increasing it if demand is strong enough for options.
Crashes also typically don't happen out of the blue, as I know from my research that roughly 70 percent of crashes (defined as the 2-3 worst days in each trading year) occur when the market is below the 200-day moving average. This is when I aim to significantly scale back the equity risk but leave the volatility risk constant to meet hedging demand–the former sees poor returns at such times but the latter sees relatively good returns due to massive hedging demand.
Source: Pension Partners
Here's an explanation of delta hedging for new readers and those who would like one.
One of my readers noted that delta hedging causes you to buy high and sell low. This is exactly correct, as it is intended to cancel out the equity exposure of the option to leave just the volatility premium. Delta hedging in this manner synthetically creates a put option to pair with the one you sold, but the hedging strategy is cheaper because it isn't certain–hence the risk premium. A cool piece of options theory is that you don't need to own the underlying to delta hedge.
For example, you can synthetically create a put selling strategy by doubling down when a stock goes down and selling when the stock goes back up. This leads to frequent wins, but occasional large losses. Few traders who pursue such strategies understand that their economic exposure is the same as a put seller, however. Here are some notes from a London-based Goldman Sachs trader on this idea.
There are a couple of takeaways here. The first is that you can look really smart if you double down your losses on the S&P 500 (or AAPL/FANG, or anything really), but expose yourself to a big hit if the market falls further than you expect. The second is that such a strategy does work more often than not, but fails to pocket the volatility premium, so if you're the kind of trader who makes these kinds of trades, you might find that selling puts would allow you to earn a premium for what you'd already do anyway.
I'll close with one of the best papers I've ever read on finance, by MIT professor Andrew Lo in 2001. Topics covered include how firefly mating patterns relate to the financial markets, how hedge fund managers can sell deep-out-of-the-money puts with excessive amounts of leverage to fool investors that their funds are low risk and high return, how daily (and monthly) return autocorrelation signals potential liquidity problems in funds, and how to time the housing market.
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Disclosure: I am/we are long QQQ, SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.