Newsletter: Capturing Volatility Risk Premium Using Butterfly Option Strategies

How to Use Butterfly Options to Capitalize on the Volatility Risk Premium

The volatility risk premium is a well-researched topic in the literature. However, less attention has been given to specific techniques for capturing it. In this issue, I'll highlight strategies for harvesting the volatility risk premium.

Web-only posts Recap

Below is a summary of the web-only posts I published during last week.

How Effective Are Stop-Loss Orders?

What Influences Stock-Bond Correlation?

Anchoring Bias and Mean Reversion: A Duo in Stock Price Dynamics

How Bitcoin Options Compare to Equity Index Options: Volatility, Correlation, and Skew

Improved Martingale Betting System- Does It Work?

Forecasting Covered Call ETF Performance

Long-Term Strategies for Harvesting Volatility Risk Premium

Reference [1] discusses long-term trading strategies for harvesting the volatility risk premium in financial markets. The authors emphasize the unique characteristics of the volatility risk premium factor and propose trading strategies to exploit it, specifically for long-term investors.

Findings

- Volatility risk premium is a well-known phenomenon in financial markets.

- Strategies designed for volatility risk premium harvesting exhibit similar risk/return characteristics. They lead to a steady rise in equity but may suffer occasional significant losses. They’re not suitable for long-term investors or investment funds with less frequent trading.

- The paper examines various volatility risk premium strategies, including straddles, butterfly spreads, strangles, condors, delta-hedged calls, delta-hedged puts, and variance swaps.

- Empirical study focuses on the S&P 500 index options market. Variance strategies show substantial differences in risk and return compared to other factor strategies.

- They are positively correlated with the market and consistently earn premiums over the study period. They are vulnerable to extreme stock market crashes but have the potential for quick recovery.

- The authors conclude that volatility risk premium is distinct from other factors, making it worthwhile to implement trading strategies to harvest it.

Reference

[1] Dörries, Julian and Korn, Olaf and Power, Gabriel, How Should the Long-term Investor Harvest Variance Risk Premiums? The Journal of Portfolio Management 50 (6) 122 – 142, 2024

Trading Butterfly Option Positions: a Long/Short Approach

A butterfly option position is an option structure that requires a combination of calls and/or puts with three different strike prices of the same maturity. Reference [2] proposes a novel trading scheme based on butterflies’ premium.

Findings

- The study calculates the rolling correlation between the Cboe Volatility Index (VIX) and butterfly options prices across different strikes for each S&P 500 stock.

- The butterfly option exhibiting the strongest positive correlation with the VIX is identified as the butterfly implied return (BIR), indicating the stock's expected return during a future market crash.

- Implementing a long-short strategy based on BIR allows for hedging against market downturns while generating an annualized alpha ranging from 3.4% to 4.7%.

-Analysis using the demand system approach shows that hedge funds favor stocks with a high BIR, while households typically take the opposite position.

-The strategy experiences negative returns at the bottom of a market crash, making it highly correlated with the pricing kernel of a representative household.

-The value-weighted average BIR across all stocks represents the butterfly implied return of the market (BIRM), which gauges the severity of a future market crash.

-BIRM has a strong impact on both the theory-based equity risk premium (negatively) and the survey-based expected return (positively).

This paper offers an interesting perspective on volatility trading. Usually, in a relative-value volatility arbitrage strategy, implied volatilities are used to assess the rich/cheapness of options positions. Here the authors utilized directly the option positions premium to evaluate their relative values.

Reference

[2] Wu, Di and Yang, Lihai, Butterfly Implied Returns, SSRN 3880815

Closing Thoughts

In summary, both papers explore strategies for capturing the volatility risk premium. The first paper highlights the distinct characteristics of the volatility risk premium and outlines trading strategies tailored for long-term investors. The second paper introduces an innovative trading scheme centered around butterfly option structures. Together, these studies contribute valuable insights into optimizing risk-adjusted returns through strategic volatility trading.

Educational Video

How to Lose Money Trading Options

In a previous issue, we featured a webinar by Dr. E. Sinclair, which covered, among other topics, the volatility risk premium. In this video, he will discuss common mistakes made by options traders and how to correct them.

The mistakes covered are:

· No Real Edge

· Ignoring Volatility

· Black Swans

· Theta Gang

· "Repairing" Positions

· Not Worrying About Costs

· Being Too Selective

· Unrealistic Expectations

Follow this link to watch the previous video.

Around the Quantosphere

- Video: Bridgewater CEO on How AI Could Change Hedge Funds (Bloomberg Live on Youtube)

- Video: Sigtech Founder, CEO Bin Ren on the Evolution of Quantitative Finance (Bloomberg Invest)

- Cliff Asness on the Trump Market, Warren Buffett, Investing Mistakes, and Hockey (msn)

- Podcast: Lyudmil Zyapkov on the relativity of volatility (risk.net)

- Millennium Loses $900 Million on Strategy Roiled by Market Chaos (Yahoo finance)

- Chaotic Market Burns Hedge Fund Strategies in February (Yahoo finance)

Upcoming Conference

Columbia Mathematics of Finance (MAFN) Future of Portfolio Management Conference is a gathering of top quantitative portfolio managers, data scientists, and AI/ML specialists. Immerse yourself in a day of learning and networking. Click here to learn about the conference agenda and register.

Recent Newsletters

Below is a summary of the weekly newsletters I sent out recently

-Understanding Mean Reversion to Enhance Portfolio Performance (9 min)

-Volatility Risk Premium: The Growing Importance of Overnight and Intraday Dynamics (12 min)

-Exploring Credit Risk: Its Influence on Equity Strategies and Risk Management (9 min)

-Hedging Efficiently: How Optimization Improves Tail Risk Protection (8 min)

-Momentum Strategies: Profitability, Predictability, and Risk Management (8 min)

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