Selling Volatility
Market participants are constantly searching for sources of excess returns. These sources can come in many forms like investing in cheap companies, high yield currencies, or short-dated corporates, to name a few. Everyone is looking for strategies that offer Sharpe ratios better than the market.
One of the most popular institutional strategies over the past decade has been harvesting what is known as the volatility risk premium (VRP). This is about to get pretty technical, so apologies in advance. To understand the VRP, we need to know about options. As a refresher, buying an option gives you the, err, option to buy or sell a stock or index at a given price. If you buy a call with a strike price of $100 that matures in 1 months, it means that in a month you are able to buy the underlying security for $100, regardless of the current price of the underlying. Clearly you will only exercise this option if the current price is over $100. If the price of the underlying is less than $100, your option is worth nothing.
A call has a great payoff profile. You have all of the upside with no downside. Since there’s rarely a free lunch in finance, you have to pay for this option. This is known as an option premium. There’s also options that payoff on the downside known as puts. If you buy a put, it allows you to sell a security at a given price, regardless of current underlying security price. These also have great payoff profiles, as if you own a stock, you can totally remove the downside by buying protection. But, like a call, you need to pay for this. You can think of it like buying insurance.
On the flipside, if you are looking to sell insurance, you can do so by going short options, or take the other side of the trade. This will often mean you make a small profit, but your downside is quite large (kind of like it is for insurance companies). To see the shape of the payoffs for going long and short both call and put options with a strike price $100, see chart below. X-axis represents the price of the underlying, and the y-axis is the payoff of the position, with the red line indicating what that payoff is.
One of the most important things to know about options is that often times they aren’t used to express a directional view of a security (I think this stock will go up or down), but that they are used to express a view on the volatility of a security (I think this stock will start going up or down more than the option price implies). To get a visual about how this works, refer to the chart below. What this shows is a distribution of stock prices given by a bell curve. “IV” stands for implied volatility, but just think of this has how risky a stock is. The blue line (25% vol) is riskier than the green (10% vol). You can see this by looking at one price, like, say, $70. If a stock has a 10% vol (green, less risky), there is not much of a chance it falls below $70. That is not the case for the 25% vol stock (blue, more risky), as its “tails” are much larger.
Let’s pretend you buy a call on a stock that’s currently trading at $100 with a 10% vol (green) at a strike price of $115, meaning it will pay off if the stock price rises above $115. Now let’s also pretend that something happens to the economy which makes the distribution of returns far more uncertain (like, say, a pandemic). Now your stock that was a 10% vol (green) is 25% vol (blue). You can see in the chart above that the area under the blue curve and to the left of $115 (blue shaded curve) is much larger, meaning the odds of your call option landing in the money is much greater than it was before (green shaded area).
Any time you buy an option that is out of the money (if it were to expire today, it’d be worthless), you are implicitly betting on there to be more volatility than expected. The more volatility, the greater chances your option pays off, meaning the more your option value grows. You are what is known as long volatility. If you sell an out of the money option, you will do better if volatility decreases, meaning you are short volatility.
Options are interesting because you can take the price they are selling at and work out what the implied volatility is. The VIX index, which describes the implied volatility of the S&P 500, used to be calculated using S&P 500 options to find the implied volatility of that index (the VIX is priced using variance swaps now, which has big implications that many don’t know about, but we’ll save that story for another day). Realized volatility is different; it tracks how volatile a stock or index actually was over the past month or year. What many people realized (sorry) was that implied volatility was usually higher than realized volatility. Said in another way, option prices overestimated what the actual volatility was. This means that going short volatility, or selling options, was a profitable strategy. This became known as the VRP.
There are some reasons for this. Remember, buying an option is akin to buying insurance. We know insurance is a loser on average, but it protects us when times are bad. Same goes for options. Most who buy options for protection know that it isn’t an average winner, but do so to protect in bad times. This can be seen in 2008 or 2020, where realized volatility was greater than option-implied. This means that being long volatility paid off. That said, on average, being short volatility used to generate significant returns for those willing to bear the risk of selling insurance.
Selling options became a very popular strategy among hedge funds, pension funds, endowments, and other institutions. Popular strategies like call overwriting (selling a call on an index or security you own) and put underwriting (selling a put option on the same) saw the number of strategies and AUM explode. There were roughly 20 of these systematic strategies and $20B in AUM in 2010, but now there are 150 strategies with $80B in AUM, and this doesn’t count the institutions running these sorts of strategies in house. So over the course of 10 years, the options markets started to have huge, price insensitive flows to sell protection for anyone willing to buy it. Whereas up until 2010, most primary market option flows were to buy protection, that has since been flipped on its head.
This had a major impact on option markets and short volatility strategies. CBOE tracks systematic strategies that sell volatility. One owns the S&P 500 while selling, or writing, calls (call overwriting) which is known as the CBOE CallWrite Index, while another owns the S&P 500 while writing puts (CBOE PutWrite Index). Both of these strategies that are short volatility outperformed the market from 1990 to 2010.
Since 2010, it has been a completely different story. This is not what the portfolio managers signed up for!
It is arguable now that buying protection has actually been profitable over the recent past, especially with the huge spike in volatility this year. Newfound Research tested performance of buying a call and a put at the same time. You can see that buying insurance was a net money loser up until 2012-ish, as buying out of the money calls and puts (known as a strangle) pretty consistently lost money aside from 2008. All of that changed after 2012 when it stopped losing money (despite historically low volatility). Then the strategy made a massive amount of money this year.
This is a perfect example of what happens when smart people do dumb things because they don’t realize there are lots of other smart people out there doing the same thing. Portfolio managers at large institutions did not understand option markets well enough to know that there’s only so much capacity for selling volatility. If too many people do it, then option buyers start to get a better deal at the expense of all of the insurance sellers. Just because markets aren’t efficient and opportunities for excess returns exist, doesn’t mean these opportunities exist forever. The VRP was an anomaly that, once discovered, saw billions of inflows to try to harvest. Anomalies have capacity constraints; they can’t be exploited forever. In this case, not only did the VRP anomaly disappear, but it created an opportunity by doing the exact opposite trade. There are so many lessons to be had here.
