Selling option premium or shorting volatility has often been compared to picking up dimes in front of a steamroller. Despite the risks and the not-too-distant blow-up of VIX- related products earlier this year, more money than ever is piling into these strategies.
And recent reports and data suggest that returns are shrinking, meaning people are now picking up pennies at the risk of being flattened by an adverse event.
The short volatility trade, where investors sell options to bet against equity price swings, is becoming less profitable. The strategy has, in theory, made no money for investors — 42% of the time since 2018, according to a report from IPS Strategic Capital, compared with a recent average of about 30% since 2012.
Funds that employ a covered call or put in writing that hope to track the Chicago Board of Options Exchange (CBOE) ‘s Buywrite , PutWrite and Iron Condor Indexes, which are all designed to track the S&P 500, begun to badly lag over the past few years as option premium is not rich enough to compensate for the fact the strategies have capped or limited profit potential.
The concept behind these strategies is that income received from selling the options provides a cushion against drawdowns, while clipping some potential gains.
The lagging performance is attributable to the deteriorating spread between implied and realized equity index volatility, which is known as the volatility risk premium.
The market tendency is to price in a higher cushion for price swings compared with what comes to pass giving traders an opportunity to sell options and earn a premium along the way and keep the premium as implied volatility ultimately reverts or converges with realized volatility.
In addition, to the billions of dollars in mutual funds using the buy-write or put selling, there are also billions tied to VIX-related products and their options; these ‘derivatives of derivatives’ creates highly-leveraged positions in which losses can quickly multiple during an adverse move.
All of this comes even as economic uncertainty index has moved to its highest level in 5 years.
It seems that with lowered returns and higher risk, these strategies are running on borrowed time before a spike in volatility can create a loss in a few days that wipes out years of gains.
VXX shares were trading at $20.56 per share on Tuesday afternoon, down $0.12 (-0.58%). Year-to-date, VXX has declined -56.25%, versus a 21.93% rise in the benchmark S&P 500 index during the same period.
About the Author: Steve Smith
Steve has more than 30 years of investment experience with an expertise in options trading. He’s written for TheStreet.com, Minyanville and currently for Option Sensei. Learn more about Steve’s background, along with links to his most recent articles. More...
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