EXTRACTING VALUE FROM VOLATILITY

Size: px

Start display at page:

Download "EXTRACTING VALUE FROM VOLATILITY"

Rosamund Waters
5 years ago
Views:

1 By Warun Kumar, Michael Davis, Brendan Finneran, and Bob Hofeman INTRODUCTION It is accepted that in order to generate returns in excess of the risk-free rate, an investment strategy must assume some risk. Generally, the greater the risk, the greater the opportunity for returns. Investors trying to outperform the riskfree rate, or more commonly a benchmark index (such as the S&P 500 ), have a range of risk factors which they can feature in an investment portfolio. Some common risk factors in the equity space include Value, Growth, Quality, and Momentum. As an example, an investor that is trying to capture the Value risk premium can overweight those stocks that exhibit stronger Value characteristics, and underweight those stocks that exhibit weaker Value characteristics. Another risk factor that is becoming increasingly popular is Volatility. We refer to this as the Volatility Risk Premium. In recent years, it has become common for investors to tilt portfolios towards lower volatility stocks in search of outperformance. But volatility is more powerful than a screening tool for stocks, and can be accessed more precisely by investors to add uncorrelated, incremental returns to an investment portfolio. WHAT IS THE VOLATILITY RISK PREMIUM? Over the past several decades, traders and investors have observed that the expected future volatility level embedded in option prices (the implied volatility ) typically exceeds the volatility that is experienced by the underlying asset during the life of the option (the realized volatility ). To make sense of this terminology, we need a bit of background on how option prices are determined. Conveniently, option prices can be reasonably estimated using well-known, closedform equations, such as the Black-Scholes formula 1. To determine an option s theoretical price (aside from supply/demand forces), a handful of inputs to the formula are needed: the underlying price, the option strike price, the maturity date (or time to maturity), the risk-free interest rate 2, the underlying dividend yield, and the expected underlying volatility over the life of the option. The problem immediately becomes clear: all of these are well-defined, observable values, except for the volatility input. What this means is that an assumption needs to be made about what the future volatility will be. Typically, the recent volatility of the underlying asset is a key component in generating this assumption, as is a view of upcoming market events. But, in order for the option to actually sell, the price (incorporating the volatility input), must be amenable to both the seller and any potential buyer. That is why the volatility input is known as the implied volatility the buyer and seller agree on a price, and then the volatility input is backed out from there. Option prices, and therefore implied volatility levels, are functions of supply and demand, just like any other traded asset. The current SPX option market is highly developed, and this price discovery process, and the associated implied volatility discovery, happens nearly instantaneously, over a million times per day. EXAMPLE: On February 11, 2016, the stock market was recovering from an especially turbulent January. We can observe that the price of a 4-week at the money SPX call option on that day was $53.69, or 2.94% of the spot price (the SPX closed at 1829). If we plug the relevant interest rate and dividend values into a simple Black Scholes model, and then search for the volatility input that solves for the known option price, we arrive at a 27.10% implied volatility level. With the benefit of hindsight, we can measure that the actual, realized volatility over the next 30 days (22 trading days) was just under 16%. This tells us that the Volatility Risk Premium on this day was in excess of 11%. 1 Fischer Black and Myron Scholes won the Nobel Prize in Economics for this work in For this discussion, we can ignore any funding costs required for hedging.

2 S&P 500 Implied/Realized Volatility Spread 3 In the chart above we can see the daily spread between the level of the VIX Index (which represents the implied volatility priced into 1- month SPX options) and the actual SPX volatility realized over the subsequent month. The first thing to notice is that the spread is nearly always positive. In fact, the spread is positive on approximately 86% of days in this sample time period. On average, this spread is 4.2%. Also included is a three-month average line, to more clearly show the general characteristics of this spread. Another thing to note in the chart is that, on occasion, the Implied/Realized spread can turn negative suddenly and dramatically. This typically happens during periods of extreme market stress. For example, in late September 2008, as the financial crisis was pushing stocks ever downward, the Implied/Realized spread hit a record negative value of -54%. This happened even with the VIX at 35%, as realized volatility over the next month turned out to be nearly 90%. The response to this was characteristic the volatility market, as represented by the VIX, quickly re-priced, reaching a record level of just over 80% by late October. By the end of the year, large positive spreads were observed, with the average spread over December 2008 exceeding 17%. Digging deeper into the characteristics of the Implied/Realized spread, we can see that its behavior can vary depending on the absolute level of implied volatility. VIX Range Spread Characteristics in VIX Ranges % of All Observations Average Spread St. Dev. of Spread % 2.30% 1.54% % 3.59% 4.03% % 4.88% 6.50% % 6.29% 11.16% % 7.22% 10.87% Over % 2.28% 16.99% Full Set 100% 4.19% 5.96% The chart above shows how the Implied/Realized volatility spread can vary depending on the VIX level. Based on the November 2008 example presented earlier, it can be tempting to chase volatility, and be a more aggressive seller of implied volatility when levels are especially high. While this strategy is often a profitable one, we can also see that the risk of this trade increases as well. WHY DOES IT EXIST? This Implied/Realized volatility spread tells us that, most of the time, options are over-priced from a volatility perspective. This makes sense if we think of options as insurance contracts. In order for an insurer to make a profit and stay in the business of selling insurance, the insurance contracts they sell need to be slightly overpriced compared to their fair value. The insurance seller prices their insurance contracts such that, even with the occasional payout (due to a flood, a car accident, a house fire, etc.), they will still come out slightly on top in the end. Similarly, option sellers understand that the future volatility of any asset is unknown (and unknowable) and they adjust the price of the options they are selling to account for this risk. The fact that so many investors are looking to buy options (specifically, SPX put options) as hedge positions against potential downside shocks, helps establish and maintain this price premium for the insurers (the option sellers). 3 Time period: 1/3/1990 9/30/2016 2

DOES IT EXIST ELSEWHERE? We can also observe that this Implied/Realized volatility spread exists in other markets for which an implied volatility index is available.

the Euro, we can see that a Volatility Risk Premium can be found across geographies and across asset classes.

3 DOES IT EXIST ELSEWHERE? We can also observe that this Implied/Realized volatility spread exists in other markets for which an implied volatility index is available. Euro (EUR) Implied/Realized Volatility Spread 7 Based on an analysis of the spreads in EuroStoxx (the benchmark European stock index), Gold (as represented by GLD), oil (as represented by USO), and the Euro, we can see that a Volatility Risk Premium can be found across geographies and across asset classes. EuroStoxx 50 Implied/Realized Volatility Spread 4 One interesting thing to note in these charts is that, while all these assets have similarly persistent Volatility Premiums, the behavior of their spreads are not the same. Meaning, while all have brief periods with negative spreads, these periods do not line up across asset classes. Cross-Asset Volatility Spread Summary Underlying Average Spread % Positive S&P % 86% Gold (GLD) Implied/Realized Volatility Spread 5 Euro Stoxx 3.8% 80% Gold 3.4% 81% Oil 5.4% 79% Euro 1.7% 81% Oil (USO) Implied/Realized Volatility Spread 6 It should also be noted that these volatility spreads cannot be found everywhere. For example, there does not appear to be evidence of a systematic, reliable volatility spread in single stocks. This is likely due to the highly idiosyncratic nature of individual equities. 4 Time period: 1/5/1999 9/30/ Time period: 6/4/2008 9/30/ Time period: 5/7/2007 9/30/ Time period: 1/7/2008 9/30/2016

4 CAN THE VOLATILITY RISK PREMIUM BE ACCESSED? In order to illustrate how the Volatility Risk Premium may be exploited, let us consider the following hypothetical proposal: PROPOSED TRANSACTION: - Brendan will pay $1 to Jonathan if the S&P 500 Index is within 5% of current levels in one week - Jonathan will pay $10 to Brendan if the S&P 500 Index level is up or down by 5% or more in one week - This same trade is repeated every week for a full year In the option markets, the type of transaction proposed above can be implemented using a commonly-traded options strategy known as a strangle. VOLATILITY RISK PREMIUM TRADING TOOLS Short Strangle: A short option strangle is a combination of a short put and a short call, both out of the money, typically significantly so. This option strategy is commonly used to sell implied volatility, as it is easy to structure and trade, and has limited exposure to the underlying asset. Short Strangle Payoff Over the course of the year, Jonathan has a maximum potential profit of $52 and a maximum potential loss of $520. Jonathan would have to win at least 48 or the 52 trades to make a profit for the year, a 92% success rate. At first glance it appears that the proposed transaction has an asymmetric risk/reward profile in Brendan s favor. Upon further investigation though, Jonathan s position looks stronger. Looking at the weekly (Friday to Friday) S&P 500 Index returns going back to , only 220 out of 4,628 weekly returns were greater than 5% or less than -5%. This equates to 4.75% of all weeks, or 2.47 weeks per year. If we start the data series in 1940, after the market histrionics related to the Great Depression, the number falls to 2.52%, or 1.31 weeks per year. This information changes the analysis significantly. Most rational investors would gladly trade a 95.25% chance of making $1 for a 4.75% chance of paying $10. What Jonathan is effectively doing is trading an implied 91% probability of break-even (the trade would be fairly priced if Jonathan had to pay out $10 once in every 11 transactions) for the expectation of a realized 95.25% probability of break-even. Put another way, the pricing is telling him he has a 9% chance of a loss, but the data tells him that probability should actually be less than 5%. As can be seen in the chart above, the short strangle (short put plus short call) results in a positive outcome when the underlying price at expiration is within the range defined by the put (on the downside) and call (on the upside) strike prices. Adding in the upfront premium earned on the option sales, the strangle seller can still be in a winning position if the expiration value is slightly outside of these strike prices. Although we know that statistically, over time, the short strangle has a positive expected outcome, we can see that there is substantial downside risk if the underlying price at expiration is significantly above/below the call/put strike price. In order to manage this risk, many practitioners have implemented a modified version of the basic strangle trade which includes long put and call options that put limits on the absolute level of risk. This option structure is known as an iron condor. 8 Time period: 12/30/1927 9/30/2016 4

Short Iron Condor: The iron condor modifies the strangle with a long put to mitigate the risk assumed by the short put, and with a long call to mitigate the risk assumed by the short call.

5 Short Iron Condor: The iron condor modifies the strangle with a long put to mitigate the risk assumed by the short put, and with a long call to mitigate the risk assumed by the short call. These long options require an upfront premium payment, so the iron condor typically generates less net upfront premium than the strangle (assuming the short options in both structures have the same strike prices). Short Condor Payoff Strategies that access the Volatility Risk Premium have become a compelling tool for investors. Income generated through these strategies that have no credit risk, no duration risk, limited equity risk (in some cases none), and are accessed through highly liquid exchange-traded instruments. In addition, many of these strategies can be accessed in unfunded form, as an overlay on an existing portfolio, meaning that investors don t have to sell existing holdings to access the benefits that the Volatility Risk Premium can provide. Past performance is no guarantee of future results. The benefit of the iron condor is that it is an effective, risk-controlled way to access the Volatility Risk Premium. In the strangle trade, every price tick below or above the put and call strike prices leads directly to losses for the seller. With the iron condor, the wider strike prices of the long put and call define the maximum loss for the iron condor seller, regardless of the further extent of the underlying move. By changing the strike prices of the various options in the structure, an iron condor seller can customize the amount of risk taken and the amount of upfront premium earned. CONCLUSION Glossary of Key Terms Call an option contract that gives the buyer the right to purchase the specified shares of the underlying stock or index at the given strike price. This creates an obligation to sell for the seller. Implied volatility the estimated volatility of a security s price which is used by option traders to price an option, based on a particular option-pricing model. Long contract a position in options in which you have purchased a contract. Premium the amount of money the buyer pays and the seller receives to engage in an option transaction. Put an option contract that gives the buyer the right to sell the specified shares of the underlying stock or index at the given strike price. This creates an obligation to purchase for the seller. Realized volatility the actual fluctuation of an underlying security s price, either up or down. Short contract a position in options in which you have written (sold) a contract. Strike (exercise) price the stated price per share for which and underlying stock may be purchased (call) or sold (put) by the long option holder. Volatility the tendency of the underlying security s market price to fluctuate up or down. In the search for incremental income, investors are typically faced with a rather limited set of choices. In the fixed income world, investors must accept lesser credits or longer duration. In the equity world, investors must concentrate their portfolios towards stocks with potentially higher dividends, such as MLPs or REITs. Any of these investments can also carry significant liquidity and transparency risk as well. The commentary is the opinion of the subadviser. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities Rampart Investment Management Co., LLC 5

Volatility Tracker -2.54% -0.25% -5.12%

Volatility Tracker -2.54% -0.25% -5.12% 1/19/21 1. Comment Last week, I noted the very wide spread between short-term realized and implied volatilities. Although the selloff on Friday alleviated conditions slightly, [5] the spread is still large