BY: HANS ALBRECHT, CIM®, FCSI, VICE-PRESIDENT, PORTFOLIO MANAGER AND OPTIONS STRATEGIST, HORIZONS ETFS
June 30, 2017
S&P 500® Index (“the Index”) options are generally priced a little too high versus actual market movement. In other words, many buyers of insurance will pay more than ‘fair value’ for options in order to protect against drawdowns and volatile market environments.
Based on an ongoing measure of realized volatility, or market movement, we call this premium over-realized movement, the Volatility Risk Premium (“VRP”). This is the premium that investors pay for insurance versus the underlying risk of movement in the Index. But why do investors pay more than they should for insurance? Buyers of protection are relatively numerous and less price-sensitive than sellers. Managers buy puts to hedge downside for their portfolios. This results in a kind of bias in the options market towards buying options. Risk-takers, or the participants who sell this insurance to them, are well-compensated to take the other side.
An allocation to a volatility trading strategy that focuses on harvesting this premium could be a good way to improve performance and add diversification to a portfolio over time. Is it a foolproof method to deliver positive returns? No. In the shorter-term, there are risks of drawdowns to the strategy. Markets will gyrate from time-to-time and volatility spikes can become severe. However, similar to a casino’s edge, given enough time, the often prevalent structural edge to harvesting volatility risk premiums should win out.
The views/opinions expressed herein may not necessarily be the views of AlphaPro Management Inc. and Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.