Boosting Your Risk-Adjusted Returns By Selling Options

As you can see from the graph above, the higher your beta is, the more you negatively skew your returns while taking more risk. Fooled by a feeling of getting rewarded handsomely, it turns out that our chances of sustainable investment success actually decrease noticeably if we choose high-risk investments.

This holds true in every country's equity market, as shown in the graph above. Low-volatility stocks produce double the Sharpe Ratio of high-risk equities by producing 25% higher returns while being 25% less risky. So, they beat the benchmark not only on a risk-adjusted basis which I believe most investors would have guessed easily (otherwise we wouldn't call them low-risk investments), but also on an absolute basis. There are, however, times when this type of factor investing will go through periods of underperformance. Lagging the broader market during market rallies by posting flat, slightly negative or less positive returns. Here's when our option selling strategy starts to kick in to create a wide profit zone wherein we make money if price changes are muted.

Low-volatility stocks are less volatile, but offer opportunities for option sellers as their historical volatility is still being overstated. That difference is known as the Variance Risk Premium. While the VIX, a proxy for the S&P-500's implied volatility, is very unpredictable and can explode from time to time, the IV for low-volatility stocks is a lot more stable. Especially this year, low-volatility stocks didn't suffer from the May and August corrections as did the S&P-500. Stabilizing IV, stable price action and good liquidity in low-volatility stocks such as NEE, AMT, DHR... present opportunities for the smart option seller.

Before investing in the VRP, or any strategy that exhibits negative skewness, you should be aware that, while such strategies can consistently accrue small and consistent gains over many years, rare, large losses disproportionately occur in bad times. It’s this poor timing of losses that helps explain the large required risk premiums. For example, a simple strategy that involves capturing the S&P 500 volatility premium lost more than 48 percent in October 2008. However, volatility premium strategies tend to recover quickly, more so than other asset classes, because it is precisely in the immediate aftermath of a crisis event when the implied volatility is highest (caution: a high implied volatility doesn’t guarantee a high return as realized volatility can continue to increase). This is similar to how insurance companies, which raise premiums after incurring large losses from catastrophic events, operate. Again, selecting individual stocks that see moderate monthly price changes is a better strategy than just utilizing the benchmark (SPY tracker) . This is especially true if you recall that the IV for the S&P-500 and other major indices is hovering near one-year lows. You're now selling cheap options with a low chance of success, which isn't necessarily the case when opting for individual low-volatility stocks! Some people sell options on futures, but that's way too risky for the individual self-directed investor...

Here's where selling premium on low-volatility stocks combines the best of both worlds: less drawdowns compared to an ordinary ETF and consistent implied volatility. Let me clarify this statement. Below you have the implied volatility chart for Danaher, DHR. We see moderate fluctuations in IV and a lot of occurrences around the 50% IVR, so we're able to sell premium when it's rich. To put some context around that, we recently sold 125/155 strangles on DHR expiring on January 17th, 2020 for 142 dollars per contract.

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