Volatility Risk When Utilizing Options

Introduction

History has shown the benefit of selling options (especially in a covered way, not via naked positions) because implied volatility tends to be overstated in the short run (for example on a monthly basis).


However, short premium strategies will be adversely impacted by increasing IV. Since we're dealing with covered positions at Option Generator AM, our portfolios will face a temporary short volatility headwind if the VIX goes up. As long as the position is covered by cash in your account or 100 shares of stock, increasing volatility will have a rather small impact on your portfolio. Let's review the volatility risk for our OG investment strategy by breaking it down into 3 segments.


1) Interpreting VIX and S&P-500 Relationship

Whenever you dig deeper into your portfolio, different factors are in play. Speaking of our real-life model portfolio shared in the monthly fact sheet, our volatility risk currently amounts to -0.19%, most of it being derived from long-term ITM CC. Per 1% change in implied volatility, this portfolio will experience a negative or positive contribution of 0.19% to our overall return.


To put some context around that number: the S&P-500 tends to decrease 0.8% in value per 1 point change in the VIX.

(Source: Option Generator Research)


More importantly, 11% of all occurrences showed a positive relationship since 1990. It is, therefore, possible that the VIX can go down when the S&P-500 goes down and vice versa. The median VIX reading equals to 18%, indicating 50% of all the data fall between 9.14 and 18 or 18 and 83.34.

(Source: Option Generator Research)


2) Changes in Vega

Understanding the impact of a 1 point change in IV on your option positions is of key importance to managing risk effectively. Consider a stock with a share price of $100 and 30 days until expiration. For an at-the-money option, changes in IV won't impact Vega. The further you go out in time, the higher the vega will be.

(Source: Option Generator Research)


As we move away from the share price, changes in implied volatility start influencing the Vega. We want to be implicitly short vega when volatility is elevated and look to reduce that risk in periods of normal-to-low IV.

(Source: Option Generator Research)


3) Look At All Your Greeks & Hedge When Necessary

If we are exposed to short vega risk, we want to offset for this additional headwind during corrections. The easiest way to lessen the negative consequences of rising implied volatility is through buying long-term puts. However, we'll have to set some boundaries as to when hedging makes sense. More information on that topic can be found in this article.


Other ways to manage our risks is through positive time decay. We're still in high IV and I'm amazed by the power of harvesting positive theta, a process many underestimate citing ALL option strategies are risky. And to be honest, this mechanism may even exceed the power of compounding over the next years... Our portfolios currently generate 3.2% in positive time value. This helps smooth out volatility risk and directional moves in our holdings.


The third manner is to have less positive delta (directional exposure to the underlying). As can be read in our next Fact Sheet about the model portfolio, our net long delta averages to 45-60 in the long run. Per 1% change in the underlying, our portfolio value will be affected by 0.45% to 0.60% (ceteris paribus).


4) Setting Up Complex Strategies in Low IV

Combining all of the elements mentioned above, complex strategies are available to us. In low-to-normal IV, these setups will lead to:

  1. a hedge

  2. lower standard deviation than holding the stock outright

  3. a high POP (Probability of Profit)

  4. low-teens returns

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