THE JOURNAL OF FALL 2016 • THEORY & PRACTICE FOR FUND MANAGERS FALL 2016 Volume 25 Number 3 A Survey of Three Derivative- Based Methods to Harvest the Volatility Premium in Equity Markets WEI GE 3 A Survey of Three Derivative- Based Methods to Harvest the Volatility Premium in Equity Markets WEI GE WEI GE t a time when interest rates are during a crisis and reap the elevated returns is a senior researcher still at historically low levels and historically observed during such situations. at Parametric Portfolio the equity market seems richly Financial derivatives, such as equity Associates LLC in Minneapolis, MN. valued, a growing number of options, variance and volatility swaps, and Ainvestors are seeking alternative sources of VIX Index-linked (Chicago Board Options [email protected] return. One such alternative source of return Exchange Market Volatility Index) options is the volatility risk premium (VRP), also or futures (Whaley [1993], Chicago Board known as the insurance risk premium (IRP). Options Exchange [2014]) that can be used The VRP refers to the observation that the to harvest the volatility risk premium, were implied volatility embedded in derivatives, in most cases developed as risk-management such as equity options or variance swaps, usu- tools. Activity in these volatility-related ally exceeds the subsequent realized volatility instruments and products experienced sig- of the underlying asset. Generally, this dif- nificant growth during the past decade, ference is most significant in broad market especially after the Global Financial Crisis. equity indexes, such as the S&P 500 Index. In particular, instruments related to the VIX, The VRP can be harvested by mechanically especially exchange-traded VIX futures, shorting and rolling the derivatives priced have gained considerable popularity among with the high implied volatilities. When investors recently. Interestingly, most inves- structured properly, the VRP can deliver tors use these derivatives mainly to protect attractive returns with low correlations to their portfolios from “tail risks,” essentially equities and fixed income assets. purchasing expensive insurance policies for The origins of the volatility risk pre- their portfolios. Investors who wish to har- mium include a combination of behavioral vest the VRP should be on the other side biases, economic factors, and structural of the trade, taking advantage of the high constraints (Ge [2014]). Overall, the VRP embedded VRP and adding a valuable addi- does not represent a market anomaly that is tional return source to their portfolios. expected to be arbitraged away. Instead, it This article examines and compares is a unique risk premium that some inves- the most commonly used strategies to mon- tors may incorporate into their portfolios. etize the VRP with three types of deriva- These investors should have long invest- tives: equity index options, variance swaps, ment horizons, stable financial foundations, and VIX futures. The article discusses the and less cyclical income sources. Investors strengths and weaknesses of the three types in the VRP behave as liquidity providers of derivatives and how they can be structured A SURVEY OF THREE DERIVATIVE-BASED METHODS TO HARVEST THE VOLATILITY PREMIUM IN EQUITY MARKETS FALL 2016 JOI-Ge.indd 48 23/08/16 12:14 pm as overlay strategies to enhance returns and keep risks in difference between option-implied volatility and subse- check. The article also discusses the historical return and quent realized volatility. One straightforward method of risk profiles of these strategies and, most importantly, harvesting the VRP is to sell index options and roll the evaluates their feasibility in portfolios from an investor’s contracts over mechanically.1 The performance of these point of view. options is primarily driven by two factors: the direc- tional movement of the underlying asset and the VRP OPTION STRATEGIES (Israelov and Nielsen [2014], Ge and Bouchey [2015]). Two option constructs have been developed to Options represent a financial contract that gives remove the directional bet component, retaining only the holder the right, but not the obligation, to buy or the volatility premium component of option trades—a sell a security at an agreed-upon price within a defined short straddle and a short strangle. In essence, straddles period or at a specified date. Options can be traded indi- and strangles are of the same design, each consisting of a vidually or combined to form complex option constructs put option and a call option at the same expiration date, with specific functions. Different forms of options have with different strike prices for strangles and the same been traded since ancient times. Modern-day equity strike price for straddles. Straddles are essentially a spe- options were traded soon after the establishment of cial type of strangle. Exhibit 1 shows the profit profiles formal stock exchanges. The Chicago Board Options of a short straddle and a short strangle. Exchange (CBOE) was established in 1973 to promote At initiation, an investor can short a strangle or standardized and exchange-traded options. Many types a straddle to collect the option premium that is pri- of options, option trading tactics, and option-based marily determined by the level of implied volatility. portfolios have been developed and thoroughly studied. The investor can make money if the ending prices of Originally developed as a risk management tool, options the underlying asset are close to the asset price when evolved to become the versatile instruments that they the contracts were initiated—a likely situation when the are today. Investors utilize options in a surprisingly wide market exhibits less volatility. In contrast, straddles and array of financial functions, from risk management to strangles lose money when the prices change significantly return enhancement, including the harvesting of the during the life of the option contracts, which tends volatility premium in equity markets. to happen when the asset prices exhibit high volatility. The VRP may be defined as the premium paid The profitability of these two constructs depends on the by option buyers to option sellers, observed as the difference between the implied volatility locked in at E XHIBIT 1 Profit Profile of a Short Straddle and a Short Strangle Notes: K, K1, K2 are strike prices; S0 is the asset price when the option contract is initiated; ST is the asset price when the option contract expires. FALL 2016 THE JOURNAL OF INVESTING JOI-Ge.indd 49 23/08/16 12:14 pm the time of sale and the subsequent realized volatility of subsequently realized volatility be lower than the implied the underlying asset. Over many trades, if the implied level. Such options are less likely to be profitable as the volatilities embedded in option prices are higher than ending prices are more likely to be in the money, neces- the subsequent realized asset volatilities, the premiums sitating a payout from the option sellers. The premiums collected by selling the options are expected to be of such options tend to be higher, though, owing to the higher than the total payouts of the option contracts heightened chance of payout. On the contrary, when caused by the realized volatilities. Short straddles and the strike prices of options are far away from S0, they strangles are methods an investor can use to monetize tend to embed much higher levels of implied volatility, the volatility risk premium indirectly. Studies show that making subsequent profits more likely, even though the using options to collect equity VRP was profitable in premiums collected tend to be lower owing to the low- most historical periods (Bakshi and Kapadia [2003], Ge ered chance of payout. As Exhibit 2 demonstrates, this and Bouchey [2015]). outcome is particularly true for out-of-the-money puts We generally recommend using call and put (e.g., strikes below S0). Lastly, note that options with options with the same delta magnitude to construct strike prices significantly different from S0 tend to have strangles, creating a delta-neutral construct with the low liquidity and should also be avoided. lowest potential correlations with the underlying asset.2 Using an option strategy to monetize the volatility When the option contracts are initiated, the strike prices risk premium has many advantages. Options are stan- (K) need to be different from the underlying asset price dardized, exchange-traded, and there is significant S0 in order to make the option trade more profitable. liquidity, depth, and diversity in the marketplace for The rationale is explained by the so-called “volatility many index and single name options. Furthermore, smile” curve, which plots the implied volatility against options can be customized easily to fit investors’ needs the strike price of an equity index option. Under normal and objectives. Because of the long history of option conditions, most index options will have an implied trading and extensive option-related research, the depth volatility curve similar to Exhibit 2. Options with of knowledge on options cannot be matched by the strike prices close to the spot price S0 tend to embed two newer strategies (variance swaps and VIX futures). low implied volatilities, making it less likely that the Short option strategies tend to have good returns and low volatility compared with the other two methods. When incorporated into a fully collateralized portfolio, E XHIBIT 2 the concerns for margin calls can be minimized. Lastly, Volatility Smile (Smirk) Observed in Option Markets carefully constructed option strategies can have an equity beta of close to zero so that the beta level stays relatively stable during market swings, providing a more predictable and uncorrelated return source to investor’s portfolios. Using an option strategy in this way also has dis- advantages. One common criticism is that the profits from options may be only indirectly linked to volatility. Indeed, an option’s ultimate profitability at expiration depends on the price of the underlying asset relative to the option strike price and not on the realized volatility levels.