Buyers of Options Can Face an Uphill Climb
S&P/TSX 60 (“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? The reasons vary but first and foremost 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, most of the time, to take the other side.
An allocation to a volatility trading strategy that focuses on harvesting this premium (VRP) 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 as we’ve seen lately surrounding certain geopolitical shocks, there are risks of drawdowns to the strategy. Markets, and volatility products in particular, can gyrate from time-to-time and spikes in fear gauges can materialize swiftly. But any large spikes in the past 15 months have been very short-lived. Regardless, similar to a casino’s edge, given enough time the prevalent structural edge to harvesting volatility risk premiums should win out in the long-run.
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.
Vice President, Portfolio Manager, and Options Strategist
Horizons ETFs Management (Canada) Inc
Hans Albrecht is vice president, portfolio manager, and options strategist at Horizons ETFs Management (Canada) Inc. He co-manages one of the largest option books in Canada, $800 million in covered call ETFs and oversees day-to-day options activities. Mr. Albrecht also was an options floor market maker and traded a large volatility book for National Bank Financial for many years. He has lectured at McGill and has appeared on numerous expert derivative panels. He has been quoted in Bloomberg, Investment Advisor, Globe and Mail, and is a regular on BNN. ETF Lipper Award winner.
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