Betting on Stability

Selling insurance against the risk of sudden price movements is a relatively simple trade to set up and access as an instrument. When the market is calm, it is also profitable. It allows for the accumulation of additional yields, especially when there were bonds with very low yields.

We are talking about the volatility carry. The trade seeks to collect an insurance premium (not in a legal sense) from investors who want to pay for protection through derivatives—in this case, options (calls or puts).

Essential to this operation is the implied volatility of prices, which consists of the market's forecast of an asset's future price and its comparison with the current price. It is an inferred volatility. Think of it intuitively like insurance. If the market believes an asset will move too much in the future, the insurance will be worth more. If the market expects stability, it will be worth less. In a valuation model, e.g., Black-Scholes, the theoretical price will match the market price of the option.

The stock costs 100, we have an ATM call (At the Money, when the call option contract—the right to buy an asset—has a strike price equal to or close to the market price of the underlying asset, so it offers no profit if exercised today—zero intrinsic value, because I can go to the market to find the same price) and the term is 1 month. Under these conditions, if the option trades at a very low price, e.g., 2, the volatility is—expectedly—low. As the option price rises, we understand that volatility rises (notwithstanding causality). Thus, if implied volatility rises by 30%, it does not mean the price will rise by 30%; rather, it means the market sees a volatility of 30% (annualized).

Now, for this trade, as long as the option's implied volatility is higher than the realized volatility of the underlying asset, the option seller will make money. If you sell an option when the implied volatility is higher than the realized volatility that ultimately occurs, what the investor is doing is selling insurance (an option) that assumed a perspective of the risk materializing that was worse than what actually happened. And, since I sold under those conditions (the market thought the volatility would be higher than what actually occurred), I sold at an expensive price, and I keep the premium.

The market thought the risk would cost 100, but in the end, the risk costs 50. You win the 50.

The aforementioned conditions, when rates were low, allowed this business to expand because there was low realized volatility, and furthermore, these insurances were cheap.

The risk for the investor who creates the trade, stating the obvious, is sudden turbulence. This can wipe out an investor, because unlike insurance companies, which measure risks magnificently, an investor faces a much larger space of uncertainty. A sudden and sustained reversal usually ruins the trade. Furthermore, it is often aggravated by herding (the herd effect), since leverage and exposure asymmetry, executed synchronously, exaggerate the losses.

It is interesting to note that options could be a substitute for de-equitization, since in recent years options trading has grown much faster than spot trading.

Consider that equity funds usually write options on those same stocks to increase the yield of those funds. Indeed, it is much more convenient, since they already hold the asset if the option is ultimately exercised.

These strategies can be complemented with directional protection. Selling a put (a bullish position, since it profits if the underlying goes up) can be hedged with another put at a lower price or by buying the underlying. The call (a bearish position, since it profits if the underlying goes down) can be hedged with another call at a higher price and the covered call (buying the underlying). However, it is not possible to hedge losses caused by the magnitude of the movements.

Lastly, Professor Alejandro Bernales, in a letter to the editor of a major newspaper, discussed the idea asserting that volatility spikes historically offer an entry point, consistent with the notion that fear overshoots and markets subsequently reverse their fall (mean reversion). He tells us that, although this pattern is well-documented, it may not tell the whole story about what elevated volatility signals.

The professor argues that recent academic evidence suggests that options markets do not only price in sentiment, but also inform trading about future volatility. The professor has a study in which he decomposes the options order flow into components related to the underlying stock values and volatility, and found that volatility-related information is both economically significant and predictive of future market conditions. In particular, he showed that volatility-driven trading increases ahead of stress episodes, indicating that at least part of the increase in implied volatility reflects informed expectations, and not just a purely behavioral overreaction.

Elevated levels of volatility may coincide with attractive future stock returns, on average, and may also signal periods when informed investors anticipate higher volatility and risk.

Volatility trading should not be viewed solely as a contrarian buy indicator, but rather as a composite measure blending sentiment with forward-looking information embedded in options markets.

The professor concludes by telling us that recognizing this distinction could help investors better understand when volatility spikes represent an opportunity and when they do not.

Therefore, the choice of these trades must weigh sentiment, but also information about future volatility.