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Systematically Harvesting the Volatility Premium

Investors can use option-writing funds to take advantage of the volatility risk premium and to diversify their equity portfolio risk.

Adam McCullough, CFA, 06/07/2017

Investors usually consider option-writing strategies as a means of generating income, or as an avenue for achieving equity-like returns with less risk. Neither categorization is necessarily wrong, but they overlook option-writing strategies’ potential diversification benefits. Equity index option-writing strategies can help diversify equity portfolios by adding exposure to the volatility premium. The volatility premium is the difference between an asset’s implied (expected) volatility and its realized (actual) volatility over a given period. Recent research has shown that the average volatility premium measured positive 3.4% per year and was positive for 88% of the months from January 1986 to December 2014 [1]. Loss aversion may be the behavioral bias that explains why option buyers chronically overprice call and put options on the S&P 500. Put buyers are essentially buying insurance to limit their downside. On the other hand, call buyers are purchasing the equivalent of a lottery ticket. They pay a small premium for a potentially large gain. In both cases, option buyers are paying up to reduce their downside.

A covered call strategy, which combines a long equity position (such as an investment in an exchange-traded fund tracking the S&P 500) with a short call option, offers straightforward exposure to the volatility premium. The option buyer has the right, but not the obligation, to purchase the S&P 500 position from the option seller for a specified price until the option expires. The option seller covers their short call option with a long S&P 500 position if the option is exercised. A put-writing strategy follows a similar dynamic, but a put option gives the option buyer the right to sell the S&P 500 to the seller at a previously specified price. So instead of holding the S&P 500 as collateral, the put seller holds a cash-like position such as short-term Treasuries to purchase the S&P 500 from the option buyer if exercised. In both cases, the option seller collects a premium from the option buyer for their trouble.

The Chicago Board Options Exchange publishes data for indexes that mimic two such option-writing strategies which systematically sell call and put options on the S&P 500. The CBOE S&P 500 BuyWrite Index (BXM) mimics the investment returns of holding the S&P 500 and selling an at-the-money (the option with a strike price nearest the current index price) call option that expires in one month. The CBOE S&P 500 PutWrite Index (PUT) replicates the returns of selling an at-the-money put option each month and holding short-term Treasuries. Like most indexes, BXM and PUT ignore transaction costs and taxes. From July 1986 through December 2016, both indexes' risk-adjusted returns, as measured by their Sharpe ratios, were greater than that of the S&P 500 Total Return Index (SPTR).


Who Are You Calling Normal?
So, these strategies offer equity-like returns with lower risk? It’s not quite that straightforward. The Sharpe ratio is an appropriate measure of risk-adjusted returns when returns are normally distributed, but option-writing strategies’ returns are not normally distributed. These call- and put-writing strategies have their upside or downside exposure capped by their at-the-money option strike and collect steady option premiums to incur this risk. These strategies’ returns don’t look like equity returns. First, they are more negatively skewed than the S&P 500’s returns. The left tail of the option-writing strategies is longer than the right tail, and the bulk of the monthly returns are on the right side of the distribution. Second, their return stream distribution curves are much steeper than the S&P 500’s, indicating that the frequency of option-writing returns is concentrated nearer the mean and is more narrowly dispersed. Exhibit 2 displays a histogram of BXM, PUT, and SPTR’s monthly return distributions from July 1986 through December 2016. The vertical axis measures the percentage of monthly returns that fall into buckets measured in 0.5% increments.

Exhibit 2: Histogram of CBOE Option Indexes and S&P 500 Monthly Returns

Both BXM and PUT’s returns generate much steeper curves. In fact, about 16% of the option-writing strategy’s monthly returns from July 1986 through December 2016 (366 months) land between 1.5% and 2.0%. SPTR’s monthly returns landed in the same bucket about half as often—8% of the time. This makes sense because the average premium collected each month on the at-the-money call and put options each month has averaged around 2.0%.

Adam McCullough, CFA, is an analyst on Morningstar’s manager research team, covering passive strategies.

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