Volatility selling strategies have performed better than one would expect through the 2008 tsunami. These strategies relate well to my previous article “Picking up Nickels in front of a Steam Roller“. The first point that they make is that up until 2008, the markets since 1990 have been relatively calm and there has been a consistent option premium that has rewarded option sellers via a positive gap between option implied volatility and actual realized volatility.
Mostly positive until 2008
The second part of the piece focused on the relative performance of different volatility strategies. They explored a 95-105 strangle (sell 5% out of the money put and 5% out of the money call), ATM Straddle (sell a put and a call at the money), Delta Hedged Straddle (sell ATM Straddle and delta hedge the straddle daily), and a recently popular Variance swap which basically pays the difference between realized and implied volatility based upon the swaps terms.
Variance Swaps - Ouch!
The first thing that stands out is that a delta hedged strategy has the highest information ratio, just think of this as the return per unit risk (standard deviation). The second most notable issues is the face that the variance swap wiped out over 5 years of gains due to 2008. The main reason for this was the incorrect pricing of the convexity premium in the variance swap, which is a fancy way of saying that the distribution of volatility was much more fat tailed than expected. On the opposite side I was very surprised by the outcome from a Naked ATM Straddle. Its rebound from the hits it took during the end of 2008 was very fast due to the mean reversion type returns of the S&P 500. In the past I had been leaning towards a 95-105 strategy, but this certainly adds some validity to the ATM strategy for those who are willing to take the added volatility of returns.
