For income, option selling conditions rarely better

Alastair MacLeod

Wheelhouse Partners

For investors seeking income, now may be the time to consider systematic option-selling strategies such as a BuyWrite. Current market conditions in the US have rarely been better.

Market volatility in the US (measured by the VIX Index) has hovered around 25 since May 2020, as the stock market recovery got fully underway. When an option is sold, this elevated volatility (Implied Volatility) is reflected in elevated option prices, meaning income is enhanced during these periods. Implied Volatility is a forward-looking measure of expected future volatility.

Alongside this elevated volatility, the actual observed risk in share prices has been declining. This is measured by Realised Volatility and is a backward-looking or historical measure.

When Implied Volatility persists at elevated levels but Realised Volatility declines, option sellers are generally being over-compensated for the risks they are assuming. This spread between Realised and Implied volatility is known as the Volatility Risk Premium (VRP). VRP has proven to be a pervasive and consistently positive source of return over time, although it can wax and wane with different market conditions.

Over the last 10 years, the VRP calculated on this basis has averaged around 3 points. This premium represents a consistent overpayment by option buyers and explains why systematic option selling strategies have generated consistently high risk-adjusted returns. However, in the past few months since the wrapping up of the US Federal election in late November, VRP has widened and is currently more than 2x the long-term average.

Source: Bloomberg

Reasons for the elevated VRP include:

  • Massive increases in single-stock call buying, driven primarily by retail investors buying upside. Single-stock call option volumes have increased 400% versus 3 years ago and there are now more single-stock option contracts trading than shares on the S&P 500 (Source GS).
  • Historically, elevated VIX levels have persisted long after risks have passed. Similar to insurance, elevated prices for options have remained in place long after the event that caused the spike in volatility.

It is unusual for the VIX Index to remain this elevated, some 30% above long-term averages, when markets are also approaching all-time highs. Looking forward, we believe it is likely that the VIX is likely to fall, or actual risk in the equity market will rise. Either way, in the current environment there appears elevated income available from systematic option-selling strategies versus being invested within equities alone.

As an aside, we also reviewed the VRP in the Australian market. While healthily positive, the current return premium appears consistent with long-term averages. This difference may be due to inconsistencies in demand for call options here versus the US. It may also be caused by Australia's lack of emerging retail trading platforms such as Robinhood.

Not already a Livewire member?

Sign up today to get free access to investment ideas and strategies from Australia’s leading investors.


Alastair MacLeod
Managing Director and Portfolio Manager
Wheelhouse Partners

Wheelhouse Partners is an independent asset manager with a speciality in risk-targeted investing. The firm manages two funds with two very different risk objectives; one a Global absolute return strategy and the other an alpha-seeking Australian...

I would like to

Only to be used for sending genuine email enquiries to the Contributor. Livewire Markets Pty Ltd reserves its right to take any legal or other appropriate action in relation to misuse of this service.

Personal Information Collection Statement
Your personal information will be passed to the Contributor and/or its authorised service provider to assist the Contributor to contact you about your investment enquiry. They are required not to use your information for any other purpose. Our privacy policy explains how we store personal information and how you may access, correct or complain about the handling of personal information.

Comments

Sign In or Join Free to comment