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Patrick Hennessy, CMT
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 to 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).
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.
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:
*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. “Is Selling Options Still Worth the Risk?” IPS Strategic Capital, 17 Sept. 2019, investps.com.
DISCLAIMER: The information on this website should not be misconstrued as an offer to buy or sell, or a solicitation to buy or sell securities. The performance data represents past performance data. With any investment, past performance is not necessarily indicative of future performance. The Absolute Return Strategy performance is representative of a size-weighted composite of the accounts managed by the firm classified as the Absolute Return Strategy-Moderate composite. The returns represent net returns of clients invested into the strategy, accounting for the 1% annual management fee. Please note that all performance in 2011 represents one non-fee paying account comprised of the firm’s capital. Due to the nature of composite performance, it cannot be guaranteed that an investor in a specific composite will receive the same gains as the size-weighted average of the composite. As of April of 2016, the separately managed accounts in the ARS–Moderate composite gain their exposure to the ARS through a 40 Act fund that utilizes the Absolute Return Strategy. The performance of the ARS shown on this sheet still represents the size-weighted average of the SMA’s that are part of the ARS-Moderate.
The Absolute Return Strategy invests in derivatives securities. Specifically, the fund sells and buys put and call options and sometimes utilizes leverage; these factors can cause portfolios invested in the strategy to show greater fluctuations than investments in the underlying assets. Prior to buying or selling an option, investors must read a copy of the Characteristics & Risks of Standardized Options. Put options give the purchaser the right, not the obligation, to sell a specified number of shares of the underlying security at a specific date in the future. The seller of a put option has the obligation, not the right, to have a number of shares delivered to them at a specified price at a specified date in the future in exchange for receiving a premium upfront for this risk. The seller of a call option has the obligation, not the right, to deliver a specified number of shares to the buyer at a specified price at a specified date in the future in exchange for receiving a premium upfront for this risk. The risk of buying either a put or call option is limited to the premium paid for said option.
The performance of the S&P 500 Index is representative of price returns not including dividends over the specified time period.
The performance of the AGG Index (Bloomberg Barclays US Aggregate Bond Index) is representative of the total return including reinvestment of dividends. These indexes are unmanaged and thus it is impossible to invest directly into these indexes.
One should always consult an investment advisor before making any investment decisions as well as consider the investment’s objectives, risks, charges and expenses carefully before investing or sending money. This and other important information about the Strategy is available upon request.
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