PARAMETRIC DELTASHIFT: USING CALL WRITING TO EXPLOIT VOLATILITY

Transcription

1 May 2015 Brad Berggren Managing Director - & Chief Investment Officer Westport Investment Center PARAMETRIC DELTASHIFT: USING CALL WRITING TO EXPLOIT VOLATILITY Parametric s DeltaShift option-overlay program is designed to improve total return and reduce volatility by systematically selling call options against an equity portfolio or concentrated stock position. Our approach seeks to take advantage of the persistent premium between implied and realized volatility. It relies on a portfolio of shorter dated maturity out-of-the-money options to reduce exercise risk and volatility based on options selection (delta) that provides greater equity exposure in higher volatility environments and less exposure in lower volatility environments. In this paper, we review evidence for the volatility premium spread and explain how our approach is different from other optionwriting programs. Parametric 1918 Eighth Avenue Suite 3100 Seattle, WA T F

2 THE VOLATILITY PREMIUM SPREAD WHAT IS IT AND WHY DOES IT PERSIST? We believe that a persistent equity and index option volatility disparity exists. Simply put, we believe there is a supply vs. demand imbalance for equity and index options. Investors generally buy call options to speculate on the potential appreciation of a stock or index and/or buy put options for protection from a potential decline. The sellers of those options, often banks, broker/ dealers and institutional traders, incur general risks and costs to hedge options positions which, in our view, effectively increases the market prices above the theoretical prices. Since the risk of hedging is an unknown, a slight risk premium generally exists. This risk premium is illustrated in the market when comparing implied volatility to the subsequent realized volatility. Implied volatility is generally the market expectation of the future volatility of an underlying stock or index as observed via the options market. The VIX is an index that measures the implied volatility of the S&P 500. While realized volatility is the actual realized volatility (standard deviation of daily returns) of the underlying equity or index. The volatility premium spread (VPS) represents the difference between the two. As seen in Figure 1, the S&P 500 s implied volatility generally has exceeded its realized volatility, by 4.4% on average from 1990 to Figure 1: Implied Volatility vs. Average Realized Volatility for S&P 500 Index Implied Minus Realized Volatility % 60.0% 40.0% 20.0% 0.0% -20.0% -40.0% -60.0% Source: Parametric, Bloomberg CBOE (1/31/ /31/2014). 1 A holder of a diversified equity portfolio or an index may be well positioned to systematically sell call options for more than their theoretical value. In a sense, these investors are natural sellers since they are already hedged ; that is, they are long the underlying asset and do not need to incur the costs associated with hedging. If the value of the underlying asset increases, resulting in an exercise of an option, we believe the investor s underlying portfolio should increase by at least as much as the exercise value. Obviously, in any non-covered transaction, the investor incurs tracking risk between the option and their actual portfolio. 1 S&P 500 Index options relative valuation is measured by taking daily observations of implied volatility (the VIX Index) and subtracting the subsequent realized volatility of the S&P 500 over the following 30 days. VIX is the Chicago Board Options Exchange volatility index. 02

3 EXPLOITING THE VOLATILITY PREMIUM SPREAD The most common use of call writing that we have observed with investors (as opposed to market makers that offset and actively hedge their exposure) is generally tactical in nature. The investor normally has a specific, one time, directional view for a period of time. Either they believe that the underlying instrument will not appreciate above the strike price in the time remaining to the option maturity or they are willing to sell the underlying instrument at that level in exchange for the receipt of option premium. A tactical implementation may play an important role in some investors portfolios but it does not, in itself, take advantage of the persistent VPS inefficiency that we have observed. After selling an option (that is not actively hedged), the outcome of that particular option is 100% attributable to the settlement price of the underlying instrument at option maturity compared to the strike price of the option. This is commonly referred to as path dependency. The VPS plays no role. In order to extract the VPS value through the sale of call options in a repeatable, strategic manner, one must sell many call options of different strike prices over many different observation periods in a quantity such that they achieve some sort of statistical significance. As the number of observations increases, the specific settlement value of each individual option (related to its path dependency) has less effect on the overall strategy of selling many calls over multiple periods, for what we observe to be, prices that are more than their theoretical value (only achieved over time with many observations). The concept is similar to the house in black jack where the odds are in the dealer s favor. A single player may or may not hit 21; but over many hands and many players, the house is expected to win in the end. A covered call is a combination of a long equity position and a short position in a call option on the same security or index. The combined portfolio limits the upside of the equity position in exchange for an option premium. Properly structured, a strategic call selling program with many observations and tight risk controls may allow investors to capture and monetize the VPS as part of their overall asset allocation and investment program. In our view, an actively managed call writing strategy may generate positive alpha under four different stock market scenarios: i. moderately rising markets ii. iii. iv. stable or flat markets moderately down trending markets sharp market declines over a short period of time Active call writing strategies do not provide protection from downside risk beyond the aggregate value of the option premium received. While the strategy should produce positive alpha in scenarios (iii) and (iv) above, the total return of the portfolio during that period would likely be down. An overlay strategy should provide investors with cash flow during the periods they may need it most, and which would then be available to help fund current obligations. This is because many of the calls written in scenarios (iii) and (iv) would most likely expire worthless for the call buyer. In strongly rising equity markets we believe a call writing strategy will generally underperform the underlying index. However, given the short-term nature of the options sold and the active rulesbased risk management utilized, in our view the portfolio value will not be capped. But, in very 03

4 strong equity markets the overall portfolio return may potentially trail the underlying index slightly. Figure 2: Risk Based Option Selection Illustration Hypothetical Results Simulation Theoretical Total Return POSITIVE RETURN 0% RETURN NEGATIVE RETURN Index depreciates Greatest expected outperformance Index modestly appreciates Expected outperformance Index appreciates sharply Expected underperformance Substantial upside participation maintained Negative Return Initial Index Level Index Appreciates Hypothetical Index Price Change Hypothetical Index Return Hypothetical Covered Call Return Source: Parametric. 3/31/2015. The above example is for demonstration and illustrative purposes only. It should not be considered investment advice or a recommendation to buy or sell any particular security or to adopt any investment strategy. Actual client experience and results will vary from the hypothetical example presented above. Successful options strategies may require the anticipation of future movements in securities prices, interest rates and other economic factors. No assurances can be given that the judgments of Parametric in this respect will be correct. There is no guarantee that the strategy will be successful. If selling calls vs. a large diversified portfolio, it is possible that the portfolio s performance diverges from that of the option underlying (basis risk). All investments are subject to potential loss of principal. Figure 2 illustrates the hypothetical performance of an overlay program versus the underlying index. The strategy outperforms (and generates excess cash flow) in down, flat and moderately up markets. Equally important is that in a significant up market, the strategy continues to appreciate, though slightly slower than the underlying index, and avoids the capped (hockey stick) payoff traditionally associated with the sale of covered calls. Below, we discuss the risk management 04

5 component of the strategy that seeks to avoid the capped nature of traditional call writing programs. DELTASHIFT DIFFERENTIATING FEATURES As our current research confirms and the previous work of others has shown, there has historically been a persistent premium between implied and realized volatility. 2 However, the implementation methodology of any strategy designed to isolate and monetize this premium is critical to the longterm success of the strategy. Arbitrary strike selection and maturity dates results in less efficient and more path-dependent outcomes. As a complement to investors long, equity portfolios, systematic, rules based index call writing implementations with risk controls, which limit the effects of path dependency, may provide more consistent returns and better isolate the VPS for investors as compared to limited observation index applications (for example the CBOE S&P 500 BuyWrite Index, or BXM). A well designed overlay program seeks to transform a theoretically designed framework into an actionable, risk-managed investment strategy. While the volatility discrepancy is observable and persistent, the sale of options results in an asymmetric liability. Selling (typically) only 12 options per year (the BXM strategy) may not result in sufficient observations to exploit the inefficiency and may unintentionally introduce concentration (date, time, notional specific) risk. The lack of active risk management further exposes the portfolio to potentially big losses that may affect the long-term goals of the portfolio. Parametric uses multiple strikes and maturities to maximize the observation set as opposed to common passive strategies that generally expose the portfolio to a single path of only 12 observations per year: We create a laddered portfolio of options with multiple strikes and maturities seeking to diversify the time/date/price-specific risk of selling call options. We use short-dated options only to minimize and seek to diversify time and event-specific risks as opposed to common passive strategies that generally expose the portfolio to widely divulged expiry and sale (roll) dates. We seek to reduce the sold call option risk by limiting the time to expiration and staggering expiries across many dates. These techniques smooth out some of the path dependency seen in more tactical option trades. CONCLUSION Our research shows that a rules-based, actively managed, risk-managed overlay strategy, in which option strikes are selected based on a measure of risk and return, may be better than one that is fixed in nature (i.e., BXM, BXY). We find that an appropriate strategy effectively indexes the strike 2 See Whaley (2002), Feldman and Roy (2005) and Hill et. al. (2006). 05

6 selection based on volatility. As volatility rises, so should strikes; as volatility falls, so should strikes. This approach provides investors with a systematic method for harvesting the volatility premium observed in option markets. REFERENCES Feldman, B.E., and D. Roy Passive Options-Based Investment Strategies: The Case of the CBOE S&P 500 Buy Write Index. Journal of Investing, vol. 14, no. 2 (Summer): Hill, J.M., V. Balasubramanian, K. Gregory, and I. Tiernens Finding Alpha via Covered Index Writing. Financial Analysts Journal, vol. 62, no. 5 (September/October): Whaley, R Return and Risk of CBOE Buy Write Monthly Index. Journal of Derivatives, vol. 10, no. 2 (Winter): About Parametric Parametric, headquartered in Seattle, WA, is a leading global asset management firm, providing investment strategies and customized exposure management to institutions and individual investors around the world. Parametric offers a variety of rules-based, risk-controlled investment strategies, including alpha-seeking equity, alternative and options strategies, as well as implementation services, including customized equity, traditional overlay and centralized portfolio management. Parametric is a majority-owned subsidiary of Eaton Vance Corp. and offers these capabilities through investment centers in Seattle, WA, Minneapolis, MN and Westport, CT (home to Parametric subsidiary Parametric Risk Advisors LLC, an SEC-registered investment adviser). Important Information and Disclosure Parametric Portfolio Associates LLC. ( Parametric ), headquartered in Seattle, Washington, is registered as an investment adviser under the United States Securities and Exchange Commission Investment Advisers Act of The DeltaShift strategy described herein is managed by Parametric s wholly-owned subsidiary Parametric Risk Advisors LLC. ( PRA ), an SEC-registered investment adviser. This information is intended solely to report on investment strategies and opportunities identified by Parametric and PRA. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. Investing entails risks and there can be no assurance that Parametric or PRA will achieve profits or avoid incurring losses. Neither Parametric nor PRA provide legal, tax and/ or accounting advice or services. Clients should consult with their own tax or legal advisor prior to entering into any transaction or strategy described herein. Charts, graphs and other visual presentations and text information were derived from internal, proprietary, and/or service vendor technology sources and/or may have been extracted from other firm data bases. As a result, the tabulation of certain reports may not precisely match other published data. Data may have originated from various sources including, but not limited to, Bloomberg, MSCI/Barra, FactSet, and/or other systems and programs. Parametric and PRA make no representation or endorsement concerning the accuracy or propriety of information received from any other third party. Options are not suitable for all investors and carry additional risks. Investors must ensure that they have read and understood the current options risk disclosure document before entering into any options transactions. In addition, investors should consult with a tax, legal and/or financial advisor prior to contemplating any derivative transactions. The options risk disclosure document can be accessed at the following web address: Options Risks Generally. The effectiveness of the option strategy is dependent upon, among other things, a general inefficiency between implied and volatility and the subsequent realized volatility. This imbalance could decrease or be eliminated, which could have an adverse effect. A decision as to whether, when and how to use options involves the exercise of skill and judgment, and even a well-conceived and well-executed options program may be adversely affected by market behavior or unexpected events. Successful options strategies may require the anticipation of future movements in securities prices, interest rates and other economic factors. No assurances can be given that the judgments of Parametric in this respect will be correct. The use of options and/or futures includes the possible imperfect correlation between the price of futures contracts and or movements in the prices of securities being hedged, and the possible absence of a liquid secondary market for any particular instrument. Portfolio holdings may need to be sold to generate cash to settle call or put options. The sale of portfolio holding may produce tax consequences for U.S. taxpayers. Please discuss with your personal tax advisor how an investment in options may affect your tax situation prior to investing. There is no assurance that the revenue received from the programs described will exceed the fees and expenses paid. All contents copyright 2015 Parametric Portfolio Associates LLC. All rights reserved. Parametric Portfolio Associates, PIOS, and Parametric with the iris flower logo are all trademarks registered in the US Patent and Trademark Office. Parametric is headquartered at th Avenue, Suite 3100, Seattle, Washington For more information regarding Parametric and its investment strategies, or to request a copy of Parametric s Form ADV, please contact us at or visit our website, com. PRA is located at 518 Riverside Avenue, Westport, Connecticut For more information regarding PRA and its investment strategies, or to request a copy of PRA s Form ADV, please contact us at