SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

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?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Investing in Private Companies

    It is axiomatic that the largest investment returns typically come from investing in private companies. Peter Thiel initially invested $500,000.00 in Facebook, which was worth over $1b when he cashed out.  Eric Lefkofsky turned an investment of $546 (that’s not a typo) into $386m in cashed out payments.

    By cwelsh,

    • 0 comments
    • 68 views
  • Option Strikes and Expirations – What's Next?

    Options expiration dates and strikes are among the most important parameters options traders must consider. Today we have the well-known weekly, monthly, cyclical, and LEAPS options. A lot of choices. But is that as far as we can go? The realm of possibilities could be endless. Consider some of these possible expansions:

    By Michael C. Thomsett,

    • 0 comments
    • 163 views
  • Buying Deep Out-Of-The-Money (DOTM) Options

    “Income” trading has become wildly popular for option traders since the global financial crisis. This style involves selling out-of-the-money options to a hedger and collecting the full premium payment at expiry — assuming the underlying doesn’t trend too hard in one direction.

    By Tyler Kling,

    • 0 comments
    • 456 views
  • The ABCs of QE And QT

    Is QE money printing or is it something else that appears to be money printing? Search the internet for “QE and money printing”, and you will see countless articles explaining why Quantitative Easing (QE) is or is not money printing. Here are a few articles that we found:

    By Michael Lebowitz,

    • 0 comments
    • 135 views
  • A Case Study in SPX Put Writing

    I've written about writing puts on multiple occasions, as I find it to be an attractive way to gain long exposure to the underlying asset class. It doesn't have to be a decision of one vs. the other (meaning, is it better to sell puts or own the underlying asset directly?), as there are advantages and disadvantages to both.

    By Jesse,

    • 0 comments
    • 235 views
  • 10 Tips: Trade Options Like a Pro and Keep Your Day Job

    Do you feel you don't have time to trade options?  This is one of the most common objections I hear from potential traders. In this article I'll give you 10 actionable tips to trade options like a pro while you balance life's other commitments.

    By Drew Hilleshiem,

    • 0 comments
    • 591 views
  • Straddles - Risks Determine When They Are Best Used

    Risk all too often is defined by the attributes of a strategy, and nothing more. However, the circumstances under which a position is opened is a better indicator of actual risk. Why? Because risk is not fixed but varies based on proximity of price to strike, and of strike to resistance or support.

    By Michael C. Thomsett,

    • 0 comments
    • 358 views
  • 4 Directional Options Trading Strategies

    Some Option traders prefer to trade mostly non directional strategies, while other option traders prefer to trade directional strategies.  Well, in the world of Options trading, there is no right or wrong answer. You can create a host of strategies based on your preferences and outlook.

    By Kim,

    • 0 comments
    • 508 views
  • Digging Deeper into the Inflation Threat

    Stoking the Embers of Inflation is one of the more important articles we have written. The Monetary Equation Identity discussed in the article provides a counterintuitive way to think about inflation. It took us a long time to accept that this identity lays out a real case for stagflation.

    By Michael Lebowitz,

    • 3 comments
    • 1,187 views
  • 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.

    By Jesse,

    • 0 comments
    • 657 views

  Report Article

We want to hear from you!


There are no comments to display.



Your content will need to be approved by a moderator

Guest
You are commenting as a guest. If you have an account, please sign in.
Add a comment...

×   Pasted as rich text.   Paste as plain text instead

  Only 75 emoticons maximum are allowed.

×   Your link has been automatically embedded.   Display as a link instead

×   Your previous content has been restored.   Clear editor

×   You cannot paste images directly. Upload or insert images from URL.

Loading...

Options Trading Blogs