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Mind the Gap: Premium Collection in a Low Volatility Environment

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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.

VIX Graph - August 1, 2017 - Bloomberg | Mind the Gap Blog Post | Swan Global Investments

Source: Bloomberg

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.

Profitability and Selling Option Premium Table | Mind the Gap Blog Post | Swan Global Investments

Source: Morn­ingstar Direct

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[1]. The chart below illus­trates this rela­tion­ship:

Unrealized vs. Realized Volatility | Mind the Gap Blog Post | Swan Global Investments

Source: Bloomberg, SG Finan­cial Engi­neer­ing

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, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsMarc 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:

[1] 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.com208-SGI-080217

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