Other than buying Ethereum, one strategy has stood out in investing circles - selling US equity market volatility, and as Goldman notes, the profitability of vol-selling strategies has accelerated in the last year. With vol at record lows, and after a long-run of success, Goldman unveils its guide to selling volatility, why it's a good idea, and how to do it.
Via Goldman Sachs,
We are increasingly asked whether flows into options and VIX selling strategies are pressuring options prices and dampening stock price moves. Indeed, when an investor sells an option, the Market Maker on the other side of the trade “delta-hedges” the portion of the trade where there is not a natural buyer. This “delta-hedging” dampens the volatility of the underlying asset from the time of the trade until expiry, all else equal. In this report, we explore the public data that is available to assess whether options and VIX ETP flows have the potential to contribute to the decline in implied and realized volatility. While a significant portion of the options market trades in OTC markets (where public data is sparse), we believe trends in OTC markets are consistent with our findings in the listed markets. In fact, based on our discussions with those that run systematic options strategies, much of OTC volume is recycled into the listed market and likely to influence publically available data.
Why are investors asking if options selling strategies are crowded?
1. Recent volatility is low and options selling returns are strong. Volatility has been low and volatility selling strategies have produced strong risk-adjusted returns over the past several years, accelerating in the past year.
For example, selling 1-month VIX futures has yielded a total return of 197% over the past year (see Exhibit 2). The average 1-month realized volatility of the SPX has been 9.1% while the options market has priced in an expected (implied) volatility of 13.5%. A variety of options sellers have benefitted from lower volatility than was priced in.
2. Low volatility environments tend to persist. Generalist investors recognize that volatility tends to stay low for an extended period of time. During the last cycle, SPX 3-month realized volatility was below 15 for nearly 4 years from Sept-2003 to July-2007. Volatility in this cycle has been below 15 for just over 1 year. The expectation for low volatility, but also fear of a cyclical pullback lead most of our questions to focus on selling covered calls (overwriting) rather than put or straddle selling strategies.
3. Fear of crowded trades after Feb 2016 “Factormaggedon”. Investors have been particularly interested in understanding crowded factors since the significant moves in factors during February 2016. We believe the narrative of “crowded strategies” travels further than usual in markets where data is less well-understood and more difficult to track than other markets as they are more difficult to refute.
Should investors sell volatility?
We see an assessment of flows as only one part of assessing the risk-reward of an investment. The strength of the fundamentals behind the investment is of primary importance followed by valuation and crowding.
1. Current fundamentals support low volatility environment. Our analysis of the correlation of volatility with major macro variables suggest that US GDP, ISM, Employment growth are consistent with low levels of volatility.
2. Equity Valuations have risen, but cash flow remains high. We find Free Cash Flow yield is the metric most closely tied to downside volatility risk for equities, whether used as a time series or cross-sectional signal. The FCF yield of the S&P 500 (ex-Financials) of 4.1% is near 30 year median levels, suggesting there is not an unusually large probability of a large drawdown. Specifically, using our GS-EQMOVE model, that incorporates FCF yield and other macro variables, we estimate a 9% probability of a 1-month 5% down-move in the SPX in the current fundamental environment.
3. Volatility is a mean-reverting asset, but mind the gap (between implied and realized). It is true that volatility is near the bottom of its multi-decade range and will increase at some point; however, investors need a large increase to offset the significant carry cost associated with buying options. We believe option buying should be done selectively ahead of events that have the potential to drive volatility.
And helpfully, Goldman explains...
Volatility selling for the Generalist: How do investors typically “sell-volatility”?
1. Overwriting: Selling calls on stocks that one owns is the most common volatility selling strategy as it both reduces equity risk and collects income.
2. Put selling: Investors sell puts to collect income in exchange for agreeing to buy a stock if it falls below the strike price before expiration. They hold collateral (cash).
3. Straddle/Strangle selling: combining Overwriting with put selling to benefit from a range-bound stock.
4. Short-VIX strategies: There are a number of VIX related ETPs that aim to replicate specific systematic VIX futures selling strategies.
And if you wondered what to buy (or sell)...
We use macro and fundamental data for S&P 500 companies to estimate the probability of large moves in the SPX to evaluate whether options are “overpriced” or “underpriced” relative to the fundamental environment. In our methodology paper “GS-EQMOVE: The probability of up and down,” June 6, 2014, we show how this analysis can be used to improve index option selling strategies over time.
Based on the current levels of ISM new orders, US Capacity Utilization, S&P 500 FCF yield and Return on Equity, we estimate there is a 16% probability of a 5% up-move over a 1-month period and a 9% probability of a 5% down-move over a 1-month period.
Calls appear significantly undervalued implying less than a 2% probability of a 5% upmove. Calls appear more attractive than 95% of the observations over the past 20-years.
Puts appear slightly overvalued implying a 12% probability of a 5% down-move. The overvaluation of puts is smaller than normal with puts less overvalued than in 87% of the observations over the past 20 years.
We have one simple question - if Goldman is so willing to 'buy' your vol, why are you 'selling'?