Global risks are rising, the Cboe’s Volatility Index is whipsawing and yet selling options is still more popular than buying. For sure, buying options means managing carry costs. But as the ongoing popularity of short vol strategies and the weight of options selling contributes to compression of the volatility risk premium, it could be time to consider (again) whether selling volatility is still worth the risk.
That, in essence, was the argument made by Dominick Paoloni, chief investment officer and founder at IPS Strategic Capital in Denver, in a recent paper he published on IPS’s website with his colleague and head trader Patrick Hennessy. The return from selling options is falling, Paoloni argued, and the return on owning optionality is rising. Since the summer, a strategy that has been buying 30-day at-the-money Standard & Poor’s calls with 10 days to expiration has outperformed comparable options selling strategies, he noted. “I think the value’s always been on the long side, but the big problem with the long side has been carry,” Paoloni said, noting that it is not easy to find strategies that can manage that. “I really think that’s the value, that’s where you get your positive convexity, if you can reduce your carry, that’s where there’s edge,” he said. IPS’ flagship long volatility mutual fund is up 8.31% net as of Sept 30. The firm also runs a suite of long volatility strategies including a long vol hedge overlay with a low carry cost and other custom-structured products, and it is about to launch a relative value strategy that trades the basis spread between the VIX and VIX futures.
Paoloni is not the only person raising concerns about vol risk premium products and touting ways to make long volatility strategies work. IPS’ paper cites work by QVR’s Benn Eifert, presented at Cboe RMC earlier this year and at Global EQD, that documented the scale of short-vol positioning. Chris Cole, founder of Artemis Capital Management, has notoriously used a sliding scale of gruesome images to depict the risks of short volatility products. His Artemis Hedgehog has also fared well in recent months. And maybe other investors are starting to catch on, too. Last week, strategists at Bank of America Merrill Lynch were pitching long volatility plays as an equity replacement strategy. “Our house view remains bullish risk assets, but an abundance of headwinds and risks are challenging a stronger move higher in U.S. equities,” strategists wrote. “Options offer attractive alternatives to outright equity exposure for investors looking to participate in a potential breakout but who remain wary of near-term risks.” The BofAML recommendation was to consider Standard & Poor’s calendar risk reversals, selling a three-month put and buying a one-month call.