Let’s say I offer you $100. But there’s a catch (isn’t there always?):
You and I must first choose from a deck of cards. If your card is higher than mine, you get the $100. If my card beats yours, you get nothing. Zip, zero, zilch, nada. Or we could forget the cards, and I’ll just give you $50. Which would you do? Would you gamble on drawing a higher card and risk getting nothing? Or would you take the sure thing and walk away with $50? Your answer says a lot about your attitude toward risk and loss, an enormously powerful human behavioral bias.
Investor behavior neatly illustrates this bias. For example, equity markets, as we know from several episodes in 2018 and more recently in May, are prone to stomach-churning spikes in market volatility. In fact, over just 14 days in May, the S&P 500® Index fell 4.5%. And while volatility, or risk, is part of the game, it’s a feature investors don’t particularly enjoy. Given a choice between two investments with equal expected returns, one with limited volatility and the other with significant return volatility, most, if not all, investors will choose limited volatility. In fact, they’re likely to choose limited volatility even if it means lower returns.
Why? The answer, according to research by psychologists Daniel Kahneman and Amos Tversky, among others who specialize in human behavior, is that people are averse to loss. That is, they generally feel much more pain from losses than they feel joy from gains. As a result, they behave in ways that minimize potential losses, even if it means forgoing large potential gains. This overall preference for greater return certainty, or risk aversion, is crucial to understanding the volatility risk premium, or VRP.
What is the VRP?
The VRP is a risk premium that option buyers pay to option sellers. Investors in the VRP are analogous to providers of insurance: They collect a premium from option buyers seeking volatility protection. This premium, or cost, covers the seller to some extent if the price of the stock underlying the option moves in a direction unfavorable to the seller. Without that premium, sellers would have no incentive to enter the market.
Historically, based on simulated data, equity index options have persistently exhibited a positive VRP, as indicated by the difference between implied and subsequently realized volatility. That is to say, most index options are priced with an elevated volatility assumption. As the chart below shows, the VRP has been positive more than 85% of the time since 1990.
Sources: Parametric, Bloomberg, 4/11/19. The time frame of 1990 to the present represents the longest period from which reliable data is available and accessible for the S&P 500® Volatility Index. S&P 500® Index options’ relative valuation is measured by taking daily observations of implied volatility (as measured by the VIX Index) and subtracting the subsequent realized volatility of the S&P 500® over the subsequent one month (assuming 21 trading days). Options have historically traded above subsequent realized volatility. Said another way, the option market tends to overestimate future volatility, which translates directly into higher prices for both puts and calls. VIX is the Chicago Board Options Exchange volatility index. VIX is calculated constantly throughout each trading day by observing the implied volatility derived from actual market prices of a wide array of put and call options with an average maturity of 30 days to expiration. For informational purposes only. It is not possible to invest directly in an index. All investments are subject to loss.
What drives the VRP?
There are three commonly accepted sources for the VRP: investors’ behavioral bias (as discussed above), economic factors, and structural constraints.
In terms of economic factors, the VRP can be viewed as compensation for withstanding certain undesirable risk-return profiles. Equity option strategies (think of them as financial insurance for equities) seek to offer protection against unfavorable price movements, and the premiums include coverage for either up or down movements.
In terms of structural constraints, as the law of supply and demand generally stipulates, short positions must carry significant premiums for the market to balance between the two sides of the equation. The potential pool for option sellers is small because selling options creates downside exposure for the seller and because they may be perceived by some as a complex investment strategy.
When can it be beneficial to use VRP strategies?
While the VRP is a complex phenomenon with multiple drivers, investment strategies designed to harvest it can be valuable throughout the market cycle. The expected premium is usually higher when the market is recovering from a tumultuous period or event, but, of course, no one can time the market successfully.
Are VRP strategies better for some investors than others?
Those investors with long-term horizons, including institutional investors and high-net-worth individuals who are willing and able to withstand the unique risks involved, may be in a good position to take advantage of the VRP and potentially harvest superior risk-adjusted long-term returns for their portfolios.
How can investors capture the VRP?
There are several possible ways to monetize the VRP, including option strategies (selling calls, puts, and straddles or strangles) and other derivative strategies. In the case of options, by systematically selling combinations of calls and puts, investors can attempt to capture the VRP effectively and consistently.
The bottom line
Many investors use VRP strategies to enhance returns while reducing overall portfolio risk—either as a complement to or replacement for traditional low-volatility equity and hedged-equity strategies, as an alternative to a traditional balanced portfolio, or as a highly liquid component within an alternative asset allocation. The persistence of the VRP means these strategies don’t have to rely on market timing or active market bets to deliver more predictable results. For investors who don’t like the wild cards that market volatility often deals, that can be a very powerful thing.