February 2, 2023
Guest Author: Ken Kwalik, Managing Partner, Carrick Lane
- The use of options in professionally managed products has remained strong for decades, even with substantial market turmoil at times.
- Investors have more choices than ever for a strategic, scalable allocation that matches their investment objectives.
- Now may be an attractive time to combine with other risk premia such as equity or fixed income to create a simple, efficient investment that fits with an investor’s views and portfolio allocation.
Options-based Strategies: Consistent Growth Gives Rise to a New Asset Class
Over the past 20+ years, options usage has evolved well beyond point-in-time transactional products, and volumes continue to increase nearly every year. Today, the options market continues to grow as more and more professionally managed products offer solutions or enhancements to several kinds of investment objectives.
This evolution is important because, after a decade of relative calm, global markets have since encountered multiple severe, far-reaching selloffs affecting all asset classes, including derivatives, over the past few years.
The global financial crisis of 2008-2009 saw the natural attrition of the hedge fund community affecting many natural options sellers on the client side. Simultaneously, several global banks with significant market-making businesses on the liquidity-provider side either downsized their derivatives footprint or became insolvent. Negative disruptions occurred once more in 2018 and 2020.
After each downturn, the industry recovered quickly and arguably came back stronger than before—with both legacy franchises and new players from all sides of the options world continuing to provide access to markets and products in a consistently functional way for investors of all types and sizes.
Current Structural State: Market Developments Help Evolve Strategies and Improve Management Flexibility
Cboe® continues to release new, innovative products including several “pure volatility” vehicles across the Cboe VIX® Index franchise and important upgrades to existing, more traditional index option products such as the Cboe-exclusive , MSCI index options and several others.
Having more strikes, terms and even daily hours to trade, without sacrificing the institutional-quality liquidity, price discovery or quote quality expected of these products, enables managers to navigate risk in a more efficient manner, and to scale total available size, customization features and more.
Two longstanding strategies familiar to investors can benefit from the expansion and growth of products in the options market:
- Collateralized put writing — an investor seeks to generate yield and/or enter an equity position, usually via selling a downside index put option and collecting premium.
- Covered call writing — an investor seeks to exit a concentrated equity position and/or generate yield, usually via selling an upside single stock or index call option and collecting premium.
Many additional strategies, such as hedged-equity, equity replacement, volatility arbitrage and others, can benefit from these developments and continue to gain significant traction.
The overall growth of these strategies over the same timespan has been strong, and with continued volatility in the core equity and fixed income markets, it is reasonable to assume growth may persist.From a client perspective, there are several important reasons for this:
1.) Simple Alignment of Investment Objectives with Core Allocation: Even just these basic strategies can solve a variety of objectives for investors, either tactically (stock exit around specific levels/events) or strategically (generating income over time via put sales), and often at the same time, implemented in different parts of a multi-asset underlying portfolio.
2.) Accessibility: Many of these strategies are available in straightforward implementations, such as separately managed accounts or fund structures, which can offer better liquidity and transparency than other liquid-alternative hedge fund structures.
3.) Efficiency: These strategies can be run as overlays, providing investors with significant potential capital efficiency (including over existing holdings, potentially in other accounts using margin), as well as potential tax-efficiency via 60/40 U.S. tax treatment of cash-settled major-market indices.
Manager offerings featuring options have increased to meet this demand, measured by not only overall assets under management but also by consistent liquidity (in listed fund vehicles) or official, GIPS-compliant/audited track records (in separately managed accounts). This is in addition to many strategies passing thorough institutional-quality due diligence, having proper ongoing research coverage and a robust presence in global investment databases with benchmarks. Product education such as Cboe’s Insights blog series and live events are an essential component of good client experience and key to responsible long-term growth.
Current Market State: The Volatility Risk Premium as a Different Return Driver
These continual structural improvements are certainly helpful for options strategies. However, it is also critical to understand the key drivers of performance, especially given the context of the past few years and recent heightened volatility.
Fundamentally, options tend to exhibit a risk premium—or demand a cost to own above their expected value. Like an equity risk premium, or a fixed-income term structure premium, this is often referred to as the volatility risk premium (VRP).Simply stated, VRP suggests that over time options tend to cost more than the underlying security would imply.Much research has been done on this topic, including a blog in this series from Seth Hickle and James Humphries of Innovative Portfolios.
Volatility Risk Premium Over the Long Term
Below is a long-term graphic of the VRP of the S&P 500 Index (SPX), annotated with the events that caused major inversions.
Source: Bloomberg and Carrick Lane
This premium can add a unique source of return to an option strategy, in addition to the directional or timing exposure. For strategies that focus on selling options, such as covered calls and collateralized puts, the best conditions for optimal returns are an underlying level of volatility that is consistently higher than realized.
The Last Five Years: Volatility Rises
Source: Bloomberg and Carrick Lane
So how does the VRP line increase given recent history? As seen in the chart above, lower absolute levels of volatility (VIX Index < 15) before the events of 2018 rose to higher levels at various points that year. While 2019 was relatively subdued, the spread of COVID-19 in 2020 and its effects on global commerce resulted in one of the highest volatility levels on record. Risk markets recovered relatively quickly as global central banks took swift action; however, implied volatility remained high, helping lead to a soundly positive VRP as significant uncertainties remained.
In 2022, markets began considering the second-order effects of the COVID imbalances, specifically inflation. Both equites and fixed income had difficult years, resulting in one of the worst years for 60/40 allocations in decades. However, despite a max drawdown of over 25% in the SPX, the average monthly VRP was still positive at +1.7 (25.5 VIX Index-implied vs 23.8 realized) suggesting that, while volatility certainly was not subdued, options sellers were generally compensated for it, resulting in an overall strong year for the space.
The Outlook for 2023
Many factors beyond the simple performance of equity earnings will likely drive the levels of volatility in 2023—such as fixed income volatility, currency volatility, monetary and fiscal policy and geopolitical events.Even if 2023 is a better year for risk overall, it’s likely we’ll see at least some continued volatility as markets continue to work through these themes.
There are several potential tailwinds for index option sellers:
1.) Absolute VIX Index levels are still at higher readings compared to long-term averages (~22 now versus ~15 long-term average).
2.) Negative VRP years tend to lead to positive readings in subsequent years.
3.) On a micro level, equity sector rotation can lead to lower correlations of index constituent movement, potentially dampening volatility. On a macro basis, fixed income and currency volatility calming might also have a similar effect.
If an investor has an even mildly constructive view on equities, put and call writing strategies could be attractive, for example:
- Covered call writing can add value in slowly appreciating markets via a combination of stock appreciation and potential option premium capture.
- Collateralized put writing can be structured to allow for further equity downside, yet still potentially capture elevated premiums via selling out-of-the-money (struck below market) puts. When collateralized by fixed income, current levels could provide not only a larger coupon than in recent history but also may benefit from price appreciation if/when rates stop rising.
In even these simple combinations, investors can tailor an allocation that can potentially benefit from these traditionally strong risk premia creating the potential to generate income and benefit from underlying price appreciation, potentially outperforming traditional long-only holdings in a more muted market. Thanks to the continued development of the options market and the providers available, investors have a flexible array of choices in education, implementation, sizing and monitoring of the strategy over time.
This article is part of Cboe’s Guest Author Series, where firms and individuals share their insights, strategies and ideas with the broader Cboe community. Interested in contributing? Email[emailprotected]or contact your Cboe representative to learn more.
There are important risks associated with transacting in any of the Cboe Company products or any of the digital assets discussed here. Before engaging in any transactions in those products or digital assets, it is important for market participants to carefully review the disclosures and disclaimers contained at:https://www.cboe.com/us_disclaimers/. The views expressed herein are those of the author and do not necessarily reflect the views of Cboe Global Markets, Inc. or any of its affiliates.
Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. The views and strategies described may not be appropriate for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations.
This material is distributed for informational purposes only. The information contained herein is based on internal research derived from various sources and does not purport to be statements of all material facts relating to the information mentioned and, while not guaranteed as to the accuracy or completeness, has been obtained from sources we believe to be reliable.
Options Risk.Options strategies entail risk. An investor’s ability to close out a position as a purchaser or seller of an over the counter or exchange-listed put or call option is dependent, in part, upon the liquidity of the option market. There are significant differences between securities and options markets that could result in an imperfect correlation among these markets, causing a given transaction not to achieve its objective.
An investor’s ability to utilize options successfully will depend on the ability of the investor to predict pertinent market movements, which cannot be assured.
Indexes are unmanaged, do not include fees or expenses and are not available for direct investment. The S&P 500 Index is considered generally representative of US large cap stocks.Cboe S&P 500 5% Put Protection Index (PPUT)is a benchmark index designed to track the performance of a hypothetical risk-management strategy that consists of a long position indexed to the S&P 500 Index (SPX & Index) and a long position in the monthly 5% Out-of-the-Money (OTM) SPX Put options.VIX Indexis a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500® Index (SPX℠) call and put options. On a global basis, it is one of the most recognized measures of volatility -- widely reported by financial media and closely followed by a variety of market participants as a daily market indicator.
Guest Author Series
Guest Author Series
Guest Author Series
I'm an options trading expert with a deep understanding of the concepts discussed in the article by Ken Kwalik, Managing Partner at Carrick Lane. The article primarily focuses on the use of options in professionally managed products and the evolution of options usage over the past two decades. Let me break down the key concepts discussed:
Options-based Strategies Evolution:
- The use of options has evolved beyond point-in-time transactions.
- Options volumes have consistently increased over the past 20+ years.
- Professionally managed products offer solutions and enhancements for various investment objectives.
Market Developments and Flexibility:
- Cboe® continues to introduce new, innovative products in the options market.
- Strategies like collateralized put writing and covered call writing have gained traction.
- The market has developed with more strikes, terms, and daily trading hours, providing increased flexibility for risk management.
Structural State and Strategies:
- Strategies like collateralized put writing and covered call writing are explained.
- Other strategies, including hedged-equity, equity replacement, and volatility arbitrage, benefit from market developments.
Reasons for Growth:
- Simple alignment of investment objectives with core allocation.
- Accessibility of these strategies through various implementations.
- Efficiency in running these strategies as overlays, providing potential capital and tax efficiency.
Volatility Risk Premium (VRP):
- Options tend to exhibit a risk premium known as the volatility risk premium (VRP).
- VRP can be a unique source of return for option strategies, especially those focusing on selling options.
Recent Market Trends:
- Analysis of volatility trends over the last five years, highlighting events like the global financial crisis and the impact of COVID-19.
- Despite volatility, options sellers were generally compensated, leading to a strong year for the options space.
Outlook for 2023:
- Factors influencing volatility in 2023, including inflation, monetary policy, and geopolitical events.
- Potential tailwinds for index option sellers, including higher VIX Index levels and historical trends.
Investor Strategies for 2023:
- Covered call writing and collateralized put writing strategies can be attractive in specific market conditions.
- Investors can tailor allocations for potential income and benefits from underlying price appreciation.
In conclusion, the article emphasizes the growth and evolution of options strategies, the importance of understanding the volatility risk premium, and potential strategies for investors in the coming year.