Mind the Gap: Premium Collection in a Low Volatility Environment
Throughout the first half of 2017, there have been two seemingly contradictory trends playing out in market volatility: low levels of implied volatility and profitability of selling option premium.
Frequently called “the fear gauge,” the VIX is actually a “guess” as to where statistical volatility (SPX volatility) will be 30- days in the future. The measurement uses a strip of out of the money call and put options which have a weighted maturity of 30 calendar days. The measurement does not use all the strikes available as it kicks out options that have no bid price and options that have a bid price but are followed by consecutive options, which have no bid price.
Trend 1: Low Levels of Implied Volatility
The first trend, the one most noticeable to market-watchers, is that levels of implied volatility have been low throughout the year. The frequently watched VIX index has been consistently on the low end of the 10–15 range through most of 2017. The last time the VIX was this low for this long was a decade ago, prior to the financial crisis.[/fusion_builder_column]
A low level on the VIX indicates that, in the short term, the market doesn’t see a whole lot of need to buy protection. Consequently, there is more supply of options versus demand. Option volatility takes into account not only the direction and speed of underlying movement but the supply and demand of options. There can be times when volatility moves either up or down without the underlying even moving; this is attributable to supply and demand. The price of options, also known as the premium, has been at depressed levels throughout the year.
Trend 2: Profitability of Selling Option Premium
The second, and seemingly contradictory, trend in the market is that strategies selling option premium have done quite well. ETFs that are short volatility futures are up around 75% for the first six months of 2017 and about 220% for the trailing year—an astonishing amount.
Huh? How can this be? If the price for volatility is so low, why are strategies that sell volatility performing so well?
The answer has to do with the gap between implied volatility and realized volatility. This is the real determinate of whether or not a short volatility trade is profitable. While the implied volatility, as described by the VIX, has been at low levels, what has actually transpired in the markets (i.e., the realized volatility) has been even lower. According to Bank of America/Merrill Lynch data cited in the Financial Times, realized volatility in the market has only been lower 3% of the time since 1928. The chart below illustrates this relationship:
Of the two lines above, the grey line represents the absolute level of implied volatility (i.e. the VIX) and the orange line represents the absolute level of realized volatility. You can see that in absolute terms, both cycle between periods of low volatility and high volatility. However, the more important element is the upper portion of the graph, which is the spread between implied and realized volatility. The green indicates positive spread and the red indicates negative spread. It is this green area where the profit potential exists, and historically, it has existed during both periods of low and high overall volatility.
How does the profitability of volatility trades work? The implied volatility is the amount of market volatility investors perceive before the fact while the realized volatility is the amount that actually occurs after the fact. The difference between the implied and the realized volatility can be thought of as the “profit margin” (the green, positive spread). Low levels of volatility do not drive the profitability of these types of trades: It is the spread that does.
What generally drives the profitability in premium collection trades is the amount of spread between implied and realized volatility not simply the absolute value of realized volatility.
Premium Collection Strategies
A premium collection strategy can take many different forms. For example, a short option strategy sells options first and then either buys the options back later at a lower price, closing at a profit, or lets the options go to expiration with the hopes that the options expire out-of-the-money and worthless.
Regardless, the trade is only profitable if the sales price exceeds the purchase price. Of course, the final profit or loss of a trade is never known in advance. Options are volatile, and it is certainly possible the price of a short option can spike and the cost of closing it out exceeds the premium originally collected.
Profit in Probability
If a person had perfect insight into the future, there would be no limit to the amount of money that person would make. In lieu of a “crystal ball” one must rely on robust and realistic probability analysis. This type of actuarial, probability analysis is frequently used in the insurance industry.
Let us turn to a theoretical example: The probability of a hurricane hitting Florida is high but the probability of a hurricane hitting Indiana is quite low. An insurance policy protecting against hurricanes in Miami should be costly, but a hurricane insurance policy in Indianapolis should be dirt cheap. Does the fact that the policy is cheap mean it is not worth anyone’s time to sell hurricane insurance in Indianapolis? On the contrary, selling hurricane insurance in Indianapolis might actually be rather lucrative if no claims are ever paid out.
Harvesting the Risk Premium
The chart above illustrating the spread between implied volatility and realized volatility indicates that more often than not that spread is positive. Would a simple, passive, mechanical, “fire and forget” trading strategy be the best way to harvest that risk premium?
Certainly, in the first six months of 2017, a passive premium collection strategy would have worked well. But anyone who is familiar with options trading should know how quickly volatility can change. Before one rushes out to buy a short VIX futures ETP (Exchange Traded Product) based on 2017’s eye-popping numbers, one should certainly understand the risks of a futures-based volatility strategy. Volatility ETPs will be discussed at length in an upcoming blog post, as part of our ongoing “Compare and Contrast” series.
It is Swan’s opinion that volatility of the short-term options market makes active management an absolute necessity. A premium harvesting strategy should be active, robust, dynamic, and responsive to market conditions. If markets are in a low volatility or a high volatility environment, a premium harvesting strategy should adjust to the market conditions. A “one size fits all” approach will likely fail. Moreover, if the markets flip from low volatility to high while a trade is in place, a good active strategy should adjust and adapt to the changing market conditions accordingly. This is what our Defined Risk Strategy seeks to accomplish.
Premium Collection and the Defined Risk Strategy
Premium collection has always been a part of the Defined Risk Strategy (DRS), but it is only one part. There is the buy-and-hold exposure to the market in the form of ETFs. There is the long-term hedge, that protects the buy-and-hold position against major market sell-offs. The premium collection is sometimes described as “the hedge of the hedge.” By design, these three are meant to work together. For 20 years, the DRS has run in this manner. Those 20 years have seen a wide array of markets: bull and bear, calm and chaotic. With these three complementary elements, Swan believes the DRS to be an “all-weather” solution.
About the Author:
Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions, is responsible for helping clients and prospects gain a detailed understanding of Swan’s Defined Risk Strategy, including how it fits into an overall investment strategy. Formerly Marc was the Director of Research for 11 years at Zephyr Associates.
Important Notes and Disclosures:
 FT Alphaville, “It’s Really Very Quiet Out There,” David Keohane, May 3, 2017
Swan Global Investments, LLC is a SEC registered Investment Advisor that specializes in managing money using the proprietary Defined Risk Strategy (“DRS”). SEC registration does not denote any special training or qualification conferred by the SEC. Swan offers and manages the DRS for investors including individuals, institutions and other investment advisor firms. Any historical numbers, awards and recognitions presented are based on the performance of a (GIPS®) composite, Swan’s DRS Select Composite, which includes non-qualified discretionary accounts invested in since inception, July 1997, and are net of fees and expenses. Swan claims compliance with the Global Investment Performance Standards (GIPS®).
All Swan products utilize the Defined Risk Strategy (“DRS”), but may vary by asset class, regulatory offering type, etc. Accordingly, all Swan DRS product offerings will have different performance results due to offering differences and comparing results among the Swan products and composites may be of limited use. All data used herein; including the statistical information, verification and performance reports are available upon request. The S&P 500 Index is a market cap weighted index of 500 widely held stocks often used as a proxy for the overall U.S. equity market. Indexes are unmanaged and have no fees or expenses. An investment cannot be made directly in an index. Swan’s investments may consist of securities which vary significantly from those in the benchmark indexes listed above and performance calculation methods may not be entirely comparable. Accordingly, comparing results shown to those of such indexes may be of limited use. The adviser’s dependence on its DRS process and judgments about the attractiveness, value and potential appreciation of particular ETFs and options in which the adviser invests or writes may prove to be incorrect and may not produce the desired results. There is no guarantee any investment or the DRS will meet its objectives. All investments involve the risk of potential investment losses as well as the potential for investment gains. Prior performance is not a guarantee of future results and there can be no assurance, and investors should not assume, that future performance will be comparable to past performance. All investment strategies have the potential for profit or loss. Further information is available upon request by contacting the company directly at 970–382-8901 or www.swanglobalinvestments.com. 208-SGI-080217