I learned a long time ago as a young broker on Wall Street that when looking at a potential trade, if the numbers look good, buy the position. Conversely if the numbers look bad, take the other side of the trade.
The popularity of exchange traded options has exploded in recent years in the investment community. Billions of dollars have been allocated into options-based strategies and mutual funds from both institutional and retail investors alike.
Cboe Global Markets (Cboe) has been a major influence in the increase of volume by publishing their suite of Strategy Benchmark Indexes. Some of the more popular strategy indexes are the Cboe S&P 500 BuyWrite Index® (BXM), Cboe S&P 500 PutWrite Index (PUT), and the Cboe S&P 500 Iron Condor Index (CNDR). These indices are based on the premise that selling options takes advantage of a well known risk premium called the volatility risk premium (VRP).
The premise is based on the insurance axiom that an option is an insurance policy on the market. The seller of insurance (options) should be paid an excess premium for the obligation of paying out on a contract. This is no different than an insurance company that is obligated to pay out on your wrecked car or your damaged home. The thought is that one can capture this risk premium by selling options when implementing equity exposure to give them better risk-adjusted returns than owning the underlying equities. However, we must not forget that selling financial insurance is not the same as selling hurricane insurance. Selling a hurricane insurance policy has no effect on the magnitude of future hurricanes, selling financial insurance can and does effect future market outcomes.
The following chart shows how the three most popular options premium-selling indices (PUT, BXM and CNDR) ex-post performance from 1990 to 2009. Note how these indices would have nicely outperformed the S&P 500.
Performance of S&P 500, PUT, BXM, and CNDR from inception (1/2/1990) to 12/31/2008. Source: Bloomberg
After looking at the chart, it’s not surprising that the “Warren Buffetts” of the world love selling insurance (GEICO Insurance).
What if Everybody Becomes an Insurance Seller?
Volatility Risk Premium estimation. Source: Macro Risk Advisors
As indicated in the chart above, as more and more investors pile into option selling strategies, two things happen. First, it increases the supply as opposed to demand of options, since there are more sellers than buyers in the market, option prices become suppressed. As a result, the excess premium between the cost and value (implied volatility – realized volatility) for selling options are suppressed. So, the question is, when is selling premium not worth the risk?
The following chart courtesy of QVR Advisors shows how the net buying/selling of options was, in vega/gamma terms, positive in the post GFC period and has continually dropped reaching almost -$400 million vega/-$100 million gamma per month in 2018. What this tells us is that the net selling of option premium has far exceeded option buying (long options creates positive vega/gamma, selling an option creates negative vega/gamma). This is most likely due to the popularity of option selling strategies in both retail and institutional communities starting in 2013.
Estimate of net S&P 500 options gamma/vega flows. Source: QVR Advisors
This phenomenon can be observed by evaluating option selling strategies since 2009 as the following chart shows. The outperformance from 1990-2009 that most likely drove massive amounts of AUM to these strategies helps to understand why they have struggled since.
Performance of S&P 500, PUT, BXM, and CNDR from 12/31/2008 to 8/28/2019. Source: Bloomberg
The chart shows that selling premium hasn’t been nearly as attractive since 2009. As we dig a little deeper and look at these short volatility indices since 2018, the performance continues to look worse.
Performance of S&P 500, PUT, BXM, and CNDR from 12/29/2017 to 8/27/2019. Source: Bloomberg
In-light-of this massive influx of option selling strategies and compressing VRP, money managers have leveraged-up option selling to keep up with their benchmarks. Once you start leveraging up, you start adding a lot of negative gamma and vega risk. This means if the markets should move drastically in one direction or the other (depending on where you are short options), strategies that were sold to the public as a safe alternative income strategies become a nightmare. One example of this is what happened to the popular mutual fund Catalyst (HFXIX) which leverage-up short calls. When the market exploded up after the Trump election, the fund fell off a cliff.
HFXIX vs S&P 500. Source: Bloomberg
The Catalyst Hedged Futures Fund (HFXIX) in yellow lost over 30% between December 2016 and March 2017. This is a common theme of many short volatility option strategies. Most of the option strategies listed in the Morningstar database are short volatility strategies (selling options to drive return).
An extreme example of how this leverage can kill is the LJM Preservation & Growth Fund. The fund’s strategy involved selling strangles on the S&P 500. As the S&P 500 marched higher in 2017, they were forced to continue leveraging up these positions to keep up with the market. After the blow off top in January 2018, holding extremely leveraged short strangle positions, the fund lost over 85% on February 5th, 2018 when XIV imploded. A fund with a 20+ year track record that navigated through volatility in 2000 and 2008 was taken out in a single day.
LJMIX vs. S&P 500. Source: Bloomberg
I am reminded of the famous quote in a book by Roger Lowenstein ‘When Genius Failed’ which is about how Long-Term Capital Management failed. He quoted an outside money manager as saying, “selling premium is like picking up nickels in front of a steam roller”. Those investors that were in some of these short option strategies that have blown-up understand this all too well.
Is it Time to Look at the Other Side of the Trade?
Since 2018, the spread between implied volatility and subsequent realized volatility has been negative over 42% of the time with observable long-tail risk (in red). In the past this has averaged closer to 30% suggesting that something is amiss.
MRAIVRP Index from 12/31/2017 – Aug 2019. Source: Bloomberg & MRA
As money pours into options selling strategies, suppressing the VRP, money managers are forced to leverage-up to keep up. Professional money managers and traders must ask the question, is the risk /return profile favorable and is it time to look at the other side of the trade?
One way we can quantify this question is to look at the other side of the trade, compare being long options instead of being short options. To drive this point home, let’s look at a strategy that has similar price exposure (e.g. 50 Deltas like the PUT and BXM indices) but takes the other side of selling options, buying options.
The chart below is a backtest of the following strategies since 12/31/2017:
- Red line – buying 30d ATM SPX calls, rolled with 10 DTE
- Blue line – selling 30d ATM SPX puts, rolled with 10 DTE
- Gold line – SPX covered call strategy, rolled with 10 DTE
- Green line – benchmark (a delta equivalent amount of the underlying, SPX)
*Note that all strategies have 50 Delta when the positions are initiated but the put write and covered call use short options to implement exposure while the long call purchases the options to implement the exposure.
Source: IPS Strategic Capital, ORATS Backtesting Data, Python, Bloomberg
Clearly, this chart shows that the edge has flipped to buying options (red line). Will this phenomenon persist or is this just an anomaly? Nobody knows; however, the truth is selling premium is alive and well and money continues to pour into these strategies, which means being long options have become relatively cheap. If you can own optionality receiving the benefit of being long gamma with a low carry cost, then you can participate in the markets upside but define your risk to the downside. Using optionality in this way, we have learned that it is possible to achieve the proverbial “have your cake and eat it too”. There are very few long option strategies in the marketplace today that are effectively exploiting this edge and are worth exploring.
*Created by Dominick Paoloni CEO of IPS Strategic Capital and Patrick Hennessy the Head Trader at IPS Strategic Capital, an investment management firm dedicated to using long option strategies that achieve uniquely superior risk mitigation and generous participation in market upside. There education content and strategies can be explored at www.investps.com.
Dominick Paoloni and Patrick Hennessy. “Are Selling Options Still Worth the Risk?” IPS Strategic Capital, 17 Sept. 2019, investps.com.