Volatility is often used as a signal to anticipate major market turning points. The CBOE Volatility Index (VIX) is popular as a gauge of investor moods, and it can swing wildly with high frequency. Volatility spikes are typically associated with declines in markets, which tend to fall faster than they rise. For example, the VIX has risen by more than 50% [see Fig 1] since U.S. President Donald Trump threatened to increase tariffs on $200 billion of Chinese goods from 10% to 25% on May 6th 2019. The most recent spike of the VIX Index was in December 2018 where the S&P 500 was down by over 9%.
The need to buy protection
If we take a closer look at market volatility, a surge in volatility usually comes after an extended period of calm and steady gains in equity markets. Since the beginning of 2019, market sentiment has largely been dictated by an expectation of a trade deal between the US and China and the Federal Reserve might even move toward easing rates to boost price pressures. As a result, the VIX has experienced the longest streak of decline in almost 5 years [see Fig 2]. And the recent spike in volatility has caused more investors to buy protection against a sharp drop in the stock markets. At the same time, the cost of protection has also increased, as reflected by VIX, a measure of how expensive the options on the S&P 500 index are.
In our previous article, we demonstrated how a portfolio can generate income with the use of options. In this short piece, we would like to discuss how options can be deployed to protect a portfolio in periods of rising uncertainty and volatility.
Protection comes with cost
Smart investors know that the optimal time to make investments is when most people are not paying attention to them. The same is true of options. Typically, PUT options [see Fig 3]
are cheapest during big bull runs. Markets tend not to value protection highly during times of strong upward momentum in markets, which makes these the best time to buy them up on the cheap. Otherwise, the options would become expensive once there is a pickup in volatility. Also, the downside of buying put options is they come at a cost, in the form of an option premium.
The value of an option
There are 6 main factors which determine the value of an option. These include the current price in the underlying security, exercise price, time to expiration, volatility, interest rates, and cash dividends. Of the 6 factors, only one is not known with any certainty: volatility.
A recap on Volatility and “VIX”
Let’s quickly review the VIX. For any option (call or put), given a price for the underlying, exercise price and time to expiration, you can use the Black-Scholes formula to calculate its implied volatility, or what market expectations are for future volatility until expiration. VIX aggregates the implied 30-day volatilities for an average of weighted prices of S&P 500 equity options over a range of strike prices. The VIX is effectively the market’s overall volatility forecast for the next 30 days.
The Volatility Risk Premium
As we know, forecasts can be right or wrong. And as it turns out, the VIX forecast is consistently wrong. When you compare VIX implied volatility forecasts to realized volatility, a distinct pattern emerges.
In Fig 4 above, the red line is the VIX implied volatility prediction for future volatility, and the blue line is the volatility that was actually realized subsequent to that measurement. In general, VIX predictions for future realized volatility tend to be too high. As you can see, there is a consistent spread, representing the Volatility Risk Premium (VRP). And the VRP spread is not insignificant, from 1990 through 2014, the VRP averaged 3.4%, and was positive 88% of the time. This refers to the phenomenon that option implied volatility tends to exceed its realized volatility of the same underlying asset over time. In other words, options have historically been overpriced.
How to maximize the risk adjusted return of buying protection?
The Volatility Risk Premium represents the compensation that investors earn for providing protection against unexpected market volatility. Hence, an investor who consistently purchases put options as portfolio insurance may have used up the capital before the next crisis occurs. Here, we would like to discuss how to purchase such protection more effectively and at a lower cost.
1) Bear put spread options:
This option strategy is to buy one put option while simultaneously selling another, which can potentially give you profit, but with reduced risk and less capital outlay. Let's take a closer
look. A bear put spread is a limited profit, limited risk options trading strategy that can be used when we moderately bearish on the underlying security. It is entered by:
buying a put options (X2) with a higher exercise price; and
selling the same number of put options (X1) with a lower exercise price on the same underlying security and the same expiration month.
One advantage of the bear put spread is that you know your maximum profit (or loss) in advance. Thus, the maximum risk for this trade is the initial cost of the spread. Therefore, you have defined your risk in advance and the cost is reduced compared
to a vanilla put option.
2) Use of option premium to pay for the protection:
In our previous article, we discussed how to generate income through option writing. In fact, the premium generated can be used to offset the cost of the put protection. For example, by selling short-dated index options, investor can use the option premium to finance the cost of downside protection. Essentially, your portfolio is insured without the need to spend much.
3) The Macro approach of looking at volatility:
As discussed earlier, options are priced by using 6 factors. The option price, however, does not fully reflect the following:
i) Valuations
ii) Macro-fundamentals
iii) Business cycles
And by taking these parameters into consideration, we can have a better understanding of the market; thus, increasing the risk-return profile when buying protection.
Conclusion
While there are lots of opportunities when investing in the stock market, it is important to protect a portfolio against adverse market movements. Through the use of stock and index
put options, investors concerned about declining markets can protect their portfolio without the need to liquidate holdings. At Pinerion, we are committed to find the opportune moment
to buy put options for protection or position for a fall in the market. Let’s fasten your seat belts and have a safe journey!
