Risk Premia Strategies - Equity Derivatives Markets
The Art of Selectively Harvesting Attractive Risk Premia
Exploiting volatility across asset classes:
Derivatives markets offer a wide range of products from listed options, OTC swaps or exotic and structured products. These products have usually been created to answer inventors' needs. However, in many areas, flows tend to build up on what is perceived to be the optimal strategy and, very logically, this accumulation is leading to an increase in the price of the demanded asset, which then tends to deviate from its fair value. This is the main source of risk premia in equity derivatives: the accumulation of flow in a specific range that is not unlimited.
One of the most illustrative examples is the hedging flow on the S&P500. Being the largest options market in the world and one of the key benchmarks for equity investors, the purchase of downside protection through S&P500 Put options is sizeable. This tends to increase the level of implied volatility (the price of the option, i.e. buying a Put or a Call is basically buying volatility), thanks to the old adage that prices are rising when there are more buyers than sellers in the market. This supply / demand imbalance in one the reasons why implied volatility is historically significantly higher than realized volatility.
Investing in these flow-driven risk premia is generally rewarding, as long as the imbalance in the flow is present. Additionally these are typically carry strategies, whereby the investor would sell an implied level and be rewarded by the differential with the actual realized volatility. That said, these strategies can also be risky and prone to severe drawdowns when flows suddenly reverse.
We explore four of the most common risk premium strategies in the equity derivatives space: short implied volatility, short VIX futures contango, Call overwriting; and long dividend yield. For each we present the general concept of the strategy and we then suggest some ways in which we can improve its risk/reward ratio.
For hedging purposes, investors are naturally buyers of protection or Puts (buyers of volatility). This imbalance between offer and demand in volatility creates a premium that can be extracted through various instruments such as volatility swaps, variance swaps, delta hedged options, straddles etc. We start with the variance swap as it is the easiest instrument to trade. In particular, it doesn’t require any active management through the lifetime of the trade (i.e. no delta hedging needed). It also offers the advantage of a pure exposure to volatility meaning that the return at expiry is proportional (but convex) to the spread between the implied volatility at inception and the realized volatility at maturity. For example, Selling a fixed amount of a variance swap every day with a one month maturity produces steadily rising returns thanks to the regular extraction of the premium embedded in implied volatility versus realized volatility. Yet this strategy is prone to dramatic and sudden drawdowns ; the 2008 bear market erased in three months all the gains accumulated in the previous five years. This comes from both the tendency of equity volatility to spike during periods of stress and the convex pay-off of variance swaps (when volatility rises, the loss associated with the short variance swap position increases more
An alternative to the use of variance swaps is the systematic sale of straddles, where investors sell both Puts and Calls of the same strike and maturity. Unlike variance swaps, straddles have linear payoffs, thus avoiding exposure to a short convexity position mentioned above. Selling straddles presents another advantage: when the underlying spot moves away from the strike (during a sell-off or a rally) and volatility rises, the vega sensitivity of the strategy diminishes, reducing the impact of the implied volatility increase. A typical strategy would consist of sell a listed straddle on a daily basis for 1/22 notional and hold it for one month, to have permanently a 100% notional exposure. Maturity could be split between the first two listed expiries. By selling on a daily basis, thus picking a new strike every day, on different maturities, we avoid having an overexposure to one pair of strike/maturity. Another way of improving the strategy is to add some kind of risk signal, which would halt the sale of straddles in the case of a "risk-off" environment. For example, we can use the VIX momentum (with a moving average indicator) to detect volatility spikes and stop selling straddles. This would significantly reduce the risk of large drawdowns.
Another short volatility strategy mentioned above is to systematically sell the volatility term structure (the curve). The general shape of the volatility term structure (different volatilities for different maturities) is upward sloping, meaning that short term volatilities are lower than longer term volatilities (i.e. the long term future is more uncertain than the short term future). Symmetrically, this contango can also be seen in the VIX futures market. In addition to this natural contango, the recent development of some ETF/ETN mirroring a long VIX futures position enhances the contango on first maturities. These ETF/ETN mirroring a long VIX futures position have to keep a constant maturity exposure, and are bound to systematically rebalance their futures positions by buying long term futures and selling short term futures. This difference in contango between the short end of the curve and the long end creates an opportunity to sell VIX futures, for example with a two month maturity and wait for the natural roll down effect. If there is no volatility spike during the life of the trade (which would invert the term structure), the future should settle lower, providing a carry gain. To hedge the short volatility exposure, we would have to buy a longer term VIX future (i.e. buying a four month maturity VIX future).
Historically, short volatility contango strategies in equity markets have offered positive returns from the difference in steepness between the nth and 1st month futures (positive 80% of the time since 2006); but they also displayed a clear short volatility bias due to the greater sensitivity of short term futures to the VIX spot (as the vol curve goes into backwardation). This explains the significant drawdowns witnessed in 2008 and 2011 on those strategies as volatilities spiked. Most strategies offer signals-based systems to automatically switch from short volatility contango positions to cash. An interesting way to correct this short volatility bias is to use a dynamic allocation between a short exposure to VIX futures and cash, with cash being held during periods of rising volatility (or when the steepness of the contango is too low). As for other short volatility strategies, these periods of rising volatility could give rise to a signal (a VIX momentum indicator), such as a moving average.
The Call overwriting strategy consists in selling short term Calls on an underlying asset in which the investor has a long position. This strategy has been around for years and is mainly used by long term investors who are required to beat a benchmark or generate a specific level of income. An improved performance, coupled with reduced volatility, are the main advantages that make overwriting a compelling strategy for long-only investors. The collected premium is proportional to the implied volatility but the return has usually no link with the realized volatility.
Historically, the outperformance of call overwriting strategies over long-only positions was most pronounced during market crashes (2008) thanks to both higher implied volatilities (premium collected) and falling underlyings. On the other hand, this type of strategies clearly suffered during strong market rallies (such as during March 2009).
Still, there are several methodologies to improve the payoff of call overwriting strategies.
The first way to improve the strategy is to remove the fixed strike constraint. The most liquid buy-write trackers (such as the BXY index) are often based on a fixed strike strategy. However, the risk in systematically selling a Call with a fixed strike is not the same in a bull or bear market or in a high or low volatility environment. For example, a 5% upside over a month when volatility is at 15% represents a 13% probability, but when volatility is 30%, the probability is 28.7%. QMS Advisors therefore recommends adopting a dynamic approach with variable strikes as a function of both the underlying's trend and its volatility regime. An easy way to adjust the strike to market conditions is to use a fixed probability of exercise instead of a fixed strike. The probability of exercise (or more easily the delta) can be calculated using a mathematical formula. In a risk-neutral framework for short-term vanilla options, the delta behaves very closely to the probability of exercise. Additionally, the delta is easily available for every option. The advantage of having a fixed probability of exercise is its flexibility. In other words, the strike is automatically adjusted to the volatility regime in order to sell the same amount of risk.
Another way to improve the return of the strategy is to take into account the momentum of the equity market. During bear markets there is an opportunity to enhance returns by selling closer to the money calls, i.e. cashing in a higher premium. That’s the reason why we recommend the use of a technical indicator to detect possible bear markets and we find that using a relative strength index (RSI) with a 30 day time frame to be the best. We label the trend bullish when the RSI >50 (above neutrality) and bearish when RSI <50. So when the RSI>50, we sell more OTM call and when the RSI<50, we sell closer to the ATM strike call. By combining the two approaches (strike flexibility and market trend), we found that the best implementation of the strategy has been:
The outperformance of this approach over a long-only position is significant during market crashes (2008) thanks to the higher implied volatility (premium collected) and falling underlying. On the other side, the strategy clearly suffers during strong market rallies (March 2009).
Implied dividend yield is yet another sub asset-class that is subject to imbalances leading to the potential emergence of a risk premium. The recent launch of listed dividend futures (i.e. EuroStoxx50) is providing much better liquidity and an access to dividends as an asset class in their own right. Longer-term dividend swaps and futures tend to be discounted because supply is in excess to demand as investment banks structured product desks are natural sellers to hedge against long-dividend risk. Being systematically long allows the investor to capture this discount by monetizing the spread between implied levels and their realized levels a few years later.
To exploit this anomaly, one could directly take a position in the EuroStoxx50 Dividend Points (DVP) Futures Index. It measures the performance of an investment strategy that invests in an equal number of the first five futures on the EuroStoxx50 DVP. In a sense, the index provides some exposure to the economic cycle (five years of dividends). The performance of the strategy can partly be explained by the discount in expected dividends. It is important to keep in mind that over the very long term dividends and equities have the same economics, and therefore, market performances. The dividend yield performance will, over multi-year periods, reflect whether the equity market has over- or under-run the profits distributed (i.e. dividends paid) by related companies. The dividend yield carry trade will work best when equity valuations are expensive (i.e. the starting point for dividends is low relative to equities).
However, the strategy can suffer big drawdowns such as seen in July 2012 when Telefonica halted its 2012 dividend whilst the market was rallying thanks to positive comments from the ECB. This highlights the binary risk associated with dividends.
Generally speaking, a volatility risk premium strategy refers to systematically selling delta-hedged options of short maturity. Here, the premium is embedded in the fact that implied volatility tends to trade above future realized volatility.
When applied to the FX option market, we consider a filter combining market sentiment with a time-series model measuring the risk premium for smoothing the returns of the strategy. While the filtered strategy mostly stays short volatility, it can also shift to neutral or long volatility positions depending on the level of market sentiment and on the impact of the bid-ask in the volatility space. If FX volatility rises, the filter embedded in the strategy will be triggered and losses should be limited as volatility moves to a higher level. Trading will eventually resume and this starting point of higher FX volatility typically implies higher returns for the strategy going forward.
This CTA type strategy has performed well since 2008, and has added large diversification value to other delta-1 FX systems which have suffered over the past few years. Furthermore, in a regime dominated by a sharp rise of implied volatility, CTA strategies are expected to outperform, thus reducing the possible drawdown associated with volatility strategies, once measured at the aggregated level. Diversification, expressed by the low correlation to delta-one FX strategies, best defines the added value of this volatility risk premium within a set of systematic strategies.
Credit volatility risk premium strategies usually take the form of delta-hedged straddles, whereby the investor sells one-month straddle options on the iTraxx Main index the day after each standard expiry date (the third Wednesday of each month) and keep the position until the next standard expiry date. The position is rolled every month (i.e. one sells a month ATM receiver and a month ATM payer) and delta-hedged on a daily basis.
This strategy consists of selling an out of the money strangle, either on rate, credit or FX options. A short strangle position is a combination of a short position on an out-of-the money Put and a short position on an out-of-the money Call. Such a strategy is highly exposed to tail risk and entails large potential drawdowns. As a compensation for this risk, the investor receives a premium, which is in proportion to the current level of volatility.
Risk management techniques can help reduce these drawdowns by, for instance, implementing simple dual risk enhancement rules: a stop loss rule based on the shadow return of the strategy and a limit to the notional invested in the strategy. A simple stop loss rule could be to use the cumulated return of the un-managed strategy: if the return cumulated over 10 days becomes negative, the investor exits the strategy. The strategy is resumed when the running 10-day return of the shadow strategy exceeds this level again. The other possible enhancement is to cap the notional on the strategy, so that the leverage remains in a pre-defined range.
Risk Premia - Eq. Derivs
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