SteadyOptions is an options trading forum where you can find solutions from top options traders. Join Us!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Does Option Selling Have Positive Expected Returns?


Academic research refers to the persistent phenomenon of ex-post implied volatility (IV) exceeding realized volatility (HV) as the Volatility Risk Premium (VRP). As it applies to option premiums, this leads to a positive expected return for being a systematic option seller.

This can be seen in historical market data, and from an efficient markets point of view, should be expected to persist in the future as a rational risk premium for the transfer of risk from a willing buyer to a willing seller.

Stop and think with me for a moment about the concept of passive vs. active. I believe it's wise to only invest in strategies ("factors") with an underlying expected return, before any active management is applied. In other words, the market naturally makes you money over time without any requirement of an investment manager's "skill" to be able to select securities and/or time entries and exits. This is important because academic research has documented manager skill in decades of historical mutual fund performance to exist less than would even be randomly expected (especially after fees and taxes).  

 

As an example of a passively managed VRP strategy, the CBOE has been publishing their S&P 500 Put write index for years, with historical data going back to 1986. Since then, a passive strategy of selling fully cash secured one-month at the money (ATM) S&P 500 puts, with collateral assumed to be held in a money market account holding US Treasury bills, would have produced returns similar to the S&P 500 index itself. Due to the nature of ATM puts, risk (measured as volatility and drawdown) was less than the underlying index, resulting in about a 30% increase in Sharpe Ratio.

cboe.png

Put selling is robust across markets as well, as can also been seen in CBOE's historical data for PUTR, where the same methodology is applied to the Russell 2000 index. With liquid option markets on ETF's like EFA and EEM, a globally diversified equity put write strategy could be constructed with attractive characteristics vs. a traditional mutual fund or ETF that only holds the underlying equities. (Readers can backtest these ideas for free for an entire week with a free trial of the highly recommended ORATS Wheel)

 

Last month, AQR published an excellent paper, Understanding the Volatility Risk Premium. The paper's executive summary is presented below:
 

image.png

 

The authors also present an interesting case study of how investor behavior tends to create significant demand for and value placed on insurance like investments, such as buying puts to hedge a position or portfolio. These preferences and behavioral biases cause an overestimation of downside risk, documented by a Yale University survey conducted where both retail and institutional investors were asked to estimate the probability of a "catastrophic stock market crash" within the next six months. Since 1989, with few exceptions, a majority of both groups consistently believe that there is a greater than 10% chance of such, yet in reality the historical likelihood of such an event has been approximately 1%. This overestimation of crash risk may be part of the explanation of the persistent VRP seen in option and volatility futures pricing where option and volatility futures buyers are willing to pay, and sellers require receipt, of a large premium to transfer risk from one party to another. 

 

On the opposite end of the option spectrum is call options, where the VRP has also been documented to exist (and can be seen in CBOE's BXMD index in the chart above), although for slightly different reasons. Call options can be thought of as lottery tickets, where a buyer spends a small amount of money to have the potential for a large payoff if the underlying asset moves much farther and faster to the upside than the market expected. This preference for positive skew results in a call option VRP that can also be captured by option sellers in a variety of different ways, including covered calls and short strangles where short puts and calls are combined into one (usually) delta neutral position.

 

I'll finish with the conclusion from AQR's paper, but before I do, a word of caution. The reason you often hear "options are risky" is because people often are under-educated about the inherent leverage built into options. Remember, one contract is the equivalent of 100 shares of the underlying. Don't rely on your broker's margin requirement as any indication of how many contracts you should sell any more than you'd rely on a sports car's ability to drive 180 MPH as any indication of how fast you should drive. In our firm, we believe that any skill that may persist in financial markets is in having a deep understanding of portfolio construction, and then the discipline to have a long term mindset when most others don't. 

 

conclusion.png

 

Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse oversees the LC Diversified forum and contributes to the Steady Condors newsletter. 

 

 

What Is SteadyOptions?

12 Years CAGR of 127.5%

Full Trading Plan

Complete Portfolio Approach

Real-time trade sharing: entry, exit, and adjustments

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Subscribe to SteadyOptions now and experience the full power of options trading!
Subscribe

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Harnessing Monte Carlo Simulations for Options Trading: A Strategic Approach

    In the world of options trading, one of the greatest challenges is determining future price ranges with enough accuracy to structure profitable trades. One method traders can leverage to enhance these predictions is Monte Carlo simulations, a powerful statistical tool that allows for the projection of a stock or ETF's future price distribution based on historical data.

    By Romuald,

    • 1 comment
    • 5,310 views
  • Is There Such A Thing As Risk-Management Within Crypto Trading?

    Any trader looking to build reliable long-term wealth is best off avoiding cryptocurrency. At least, this is a message that the experts have been touting since crypto entered the trading sphere and, in many ways, they aren’t wrong. The volatile nature of cryptocurrencies alone places them very much in the red danger zone of high-risk investments.

    By Kim,

    • 0 comments
    • 1,401 views
  • Is There A ‘Free Lunch’ In Options?

     

    In olden times, alchemists would search for the philosopher’s stone, the material that would turn other materials into gold. Option traders likewise sometimes overtly, sometimes secretly hope to find something which is even sweeter than being able to play video games for money with Moincoins, that most elusive of all option positions: the risk free trade with guaranteed positive outcome.

    By TrustyJules,

    • 1 comment
    • 17,435 views
  • What Are Covered Calls And How Do They Work?

    A covered call is an options trading strategy where an investor holds a long position in an asset (most usually an equity) and sells call options on that same asset. This strategy can generate additional income from the premium received for selling the call options.

    By Kim,

    • 0 comments
    • 2,875 views
  • SPX Options vs. SPY Options: Which Should I Trade?

    Trading options on the S&P 500 is a popular way to make money on the index. There are several ways traders use this index, but two of the most popular are to trade options on SPX or SPY. One key difference between the two is that SPX options are based on the index, while SPY options are based on an exchange-traded fund (ETF) that tracks the index.

    By Mark Wolfinger,

    • 0 comments
    • 7,040 views
  • Yes, We Are Playing Not to Lose!

    There are many trading quotes from different traders/investors, but this one is one of my favorites: “In trading/investing it's not about how much you make, but how much you don't lose" - Bernard Baruch. At SteadyOptions, this has been one of our major goals in the last 12 years.

    By Kim,

    • 0 comments
    • 4,224 views
  • The Impact of Implied Volatility (IV) on Popular Options Trades

    You’ll often read that a given option trade is either vega positive (meaning that IV rising will help it and IV falling will hurt it) or vega negative (meaning IV falling will help and IV rising will hurt).   However, in fact many popular options spreads can be either vega positive or vega negative depending where where the stock price is relative to the spread strikes.  

    By Yowster,

    • 0 comments
    • 6,601 views
  • Please Follow Me Inside The Insiders

    The greatest joy in investing in options is when you are right on direction. It’s really hard to beat any return that is based on a correct options bet on the direction of a stock, which is why we spend much of our time poring over charts, historical analysis, Elliot waves, RSI and what not.

    By TrustyJules,

    • 0 comments
    • 3,825 views
  • Trading Earnings With Ratio Spread

    A 1x2 ratio spread with call options is created by selling one lower-strike call and buying two higher-strike calls. This strategy can be established for either a net credit or for a net debit, depending on the time to expiration, the percentage distance between the strike prices and the level of volatility.

    By TrustyJules,

    • 0 comments
    • 4,948 views
  • SteadyOptions 2023 - Year In Review

    2023 marks our 12th year as a public trading service. We closed 192 winners out of 282 trades (68.1% winning ratio). Our model portfolio produced 112.2% compounded gain on the whole account based on 10% allocation per trade. We had only one losing month and one essentially breakeven in 2023. 

    By Kim,

    • 0 comments
    • 9,475 views

  • Upvote 2
  Report Article

We want to hear from you!


There are no comments to display.



Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs