Short Option Overlay for Trend Positions

One of the most frustrating things about a long- and medium-term trend strategy (including the super long-term trend following idea of buying-and-holding market cap weighted indices) is that prices seem to spend most of the time going nowhere and often retrace to give back a portion of those nice book profits.

Wouldn’t it be nice to earn some additional income in those frustrating times?

In this article, I will tackle some lucrative ideas and go from basic concepts to concrete methods to implement exactly that in a portfolio in practice.

Price Change and Carry

Where do the profits in a portfolio actually come from?
The main sources are not only the obvious – the change in price of an asset -, but also the more hidden returns from carry: the profits you earn when absolutely nothing changes.
Whenever I scrutinize my portfolio performance, I usually realize that carry actually accounts for the majority of my profits and, more importantly, is the most stable source of income – I always look for ways to harvest more of it.

Dividends and Yield

The most basic sources of carry, that can be found in virtually all portfolios, are the dividends paid by stocks and the coupons that make up a bond´s yield.
It is quite well known, that historically over half of the return of equity markets comes from (re-invested) dividends and less than half from actual changes in stock prices. Dividend payments also tend to be a lot less volatile than stock prices.
That has made dividend strategies some of the most popular investing strategies out there.
These strategies work well when dividends capture some of the value factor, but there can be times when dividend stocks are quite expensive and likely to underperform in the future. Dividend investing is basically an inefficient form of value investing – using a composite value screen usually is a better strategy.
In recent years many companies have chosen stock buybacks over paying dividends, which means that shareholder yield (dividends + buybacks) is the more up-to-date way to screen for carry in equities.

Other Forms of Carry

Less well known are the sources of carry in unproductive assets like commodities and also in currencies and real estate, but they should definitely be taken into account in our investment strategies, when we look at returns on a risk-adjusted basis:
  • Roll yield in commodities: commodities have essentially produced no real return over the long haul, but the strategy of only buying commodity futures in backwardation (meaning that there is a positive yield when rolling from one future to the next at expiration) created equity-like returns.
  • Currency carry strategies, that buy the currencies of countries that pay the highest interest rates, have also yielded equity-like returns.
  • Price appreciation in real estate has historically been only as high as inflation (just as with commodities), but the rental yield made overall returns – you guessed it – equity like.
Even more obscure and also one of the best sources of carry is the volatility risk premium and its possibilities to create additional sources of carry for many assets are quite interesting.

Creating Carry

The term “volatility risk premium“ is not very accessible and even its explanation makes no immediate sense of how an actual profit could be made from it. The mechanics are more complex, hidden and harder to access than with many other risk premia. It has insurance-like properties combining high demand and high crash risks, which is why it works well and will likely be a sustainable source of superior returns for investors willing to shoulder that risk.

Volatility risk premium simply describes the fact that the market consistently overestimates an assets volatility on average: the expected volatility is usually higher than the volatility that actually occurs. It is called a risk premium, because sometimes the reverse happens – this can be quite severe as volatility tends to spike up violently from time to time.
The easiest way to explain how this translates into returns (and risk of loss) is through the concepts of optionality, insurance and lottery tickets:
Giving someone the option to buy or sell something for a specific price at some point in the future is rewarded by a premium. If nothing changes during that time, the seller gets to keep the premium – it is a form of carry. The size of the premium is strongly influenced by the volatility of the asset, because higher volatility makes it more likely that a favorable outcome for the buyer of the option occurs – the option becomes more expensive.
Many investors want to buy insurance for their portfolio and they usually do this by buying put options, that give them the right to sell their assets at a fixed price in the future even if the actual price at the time has fallen to much lower levels. The seller of such insurance takes on the risk for the buyer and wants to be adequately compensated for it. As demand for insurance is high this is usually the case, but the level of compensation varies over time.
The reverse is also true, but not as high in demand and therefore paying lower premia:
Investors buy overpriced lottery tickets in the form of call options to make a leveraged bet on an asset´s price to rise – the seller takes on the risk of having to pay out high winnings.
Empirically the volatility premium is visible in the VIX Futures Term Structure, which looks something like this about 80% of the time:

Sellers of volatility futures demand higher prices the further out in time you go, just in case equity markets suddenly drop and volatility shoots up.
Most of the time this doesn’t happen and the buyer has to pay a roll yield each month – very expensive crash insurance at about 4% monthly in the chart example. This is the reason that being constantly short VIX futures, whenever the term structure is in contango (as in the graph above), is the best strategy in my portfolio for the market conditions of recent years.
Conversely, whenever the term structure inverts, the strategy is exposed to high crash risk – to mitigate this I employ strict exit criteria to exit all positions when the term structure moves into backwardation.

Let´s get practical

How can we harvest this volatility premium in as many forms as possible?

Explicit Short Volatility Strategies – selling options and VIX Futures systematically – are a cornerstone of my portfolio and described in detail in this post.
In addition to shorting volatility actively, the positions we hold in our portfolio (with the frustrating tendency to do nothing for us most of the time) have the dormant potential for us to create carry premia at no additional risk except for some opportunity costs.

Covered Calls
The mainstream option writing strategy, which is allowed to be implemented in many retirement accounts, is the covered call strategy.
Conceptionally it does the opposite of what you hold a portfolio asset for: it capitalizes on mean reversion in a trending position and makes money during the frequent times of retracements and sideways moves. This feels a bit strange at first – after all you bought the position, because you thought it will go up – but in fact you combine a trend strategy with a mean reversion component. This in effect suppresses volatility and enhances return in the long run.

In the paper “Covered Calls Uncovered” AQR describes how the strategy is exposed to three return components: the equity risk premium, a bet on a equity market reversal and the volatility risk premium. Most interesting is the point, that, while the short volatility exposure contributes little risk (less than 10% of the strategy’s risk), it adds about 2% annualized return due to its high Sharpe ratio near 1.0.

Writing a covered call (ie. selling a call option on a position you own) creates an additional income stream and buffers your downside (and thereby volatility) through premia received, but in exchange you have to cap the upside potential of your position at a certain point – the strike price.
If this price is not exceeded at the option´s expiration date, you simply get to keep the premium.
If the price is higher, your position is called away (sold) at the strike price (so this should always be a price you are happy to sell at).
For a long-term position with big book profits this might have considerable tax implications and the added hassle (and commissions) of having to re-enter the position after it was called away. This can easily be avoided by simply covering the call (buying it back) a couple of days before expiration. You will still earn the majority of the premium minus the difference between the stock´s price and the strike.
The strategy is so popular, that “investors recently have allocated more than $20 billion in at least 40 buy-write funds“ according to the CBOE, which also publishes a number of indices for different methods to set the strike price, which makes it easy to get a performance comparison.
The most practical approach is taken by BXY (writing 2% out-of-the-money calls on the S&P 500) or BXMD (which is a bit more refined as it includes the specific volatility of the underlying by using a option delta of 30 to set the strike price) – this paper does a great job for us in analyzing the past performance of the strategy (graph from the 2012 analysis by the Asset Consulting Group):

The best performers are found up (highest returns) and left (lowest volatility).
The simple BXY strategy enhances the return (by 1,3 percentage points annually) and lowers the volatility (by 2,5 percentage points) of the underlying S&P 500 considerably – this gives us a great base case for the value of a covered call strategy.
You will notice in the graph, that PUT beats BXY by a wide margin, especially  at reducing volatility (50% lower than the S&P 500!) – PUT is the index for a generic put writing strategy and is the basic rationale behind the systematic option writing strategy I linked to above. The superior results are caused by the demand for insurance in the market resulting in higher put premia – because insurance buyers overpay willingly these results are likely very robust.
Such dampened volatility is of immense value as the resulting lower drawdowns are much easier to tolerate or conversely returns could be enhanced by 50% by using 1,5 times leverage resulting in a level of volatility equal to the S&P 500.
In practice I concentrate most on systematic naked option writing in my portfolio (using puts, calls and some leverage) and use covered calls only opportunistically (e.g. to hedge part of a run-up in price in a position). Most of the time the un-leveraged call premia are too small to make the effort worthwhile for me (the strategy’s popularity brings a supply of sellers to the market that results in a lower risk premium) and many of the ETF, I use in my portfolio, have no options available.
But recently the concept of carry and covered options positions have started to play a bigger part in the trend-following strategy, I started trading at the end of 2017 – it uses futures contracts across all liquid asset classes (equities, bonds, commodities and currencies). This systematic strategy inherently uses a higher level of leverage which makes the size of the option premium considerably more attractive.

Double Carry with Managed Futures
In a medium-term trend-following strategy, even more so than with my long-term positions, I noticed many initially profitable positions going nowhere for long periods of time or – quite frustratingly – give back considerable profits (often to be stopped out at a breakeven point).
To address this, I stressed the available carry as a selection criterium at first: in some commodities roll yield can make up more than 1% monthly either acting as a tail- or headwind, depending on the direction you trade.

I make sure to only trade commodity and currency positions where roll yield and trend are aligned – these positions earn money even if the spot price doesn’t move.

Additionally I started to create carry, by writing covered put (on short positions) and call options to lock in some book profits while keeping trend positions running. This also smoothes daily volatility nicely – the option position´s value initially moves about one third to one half of the underlying position, but in the opposite direction.
Even when an initially profitable position is stopped out at breakeven I want to keep the option premium as a profit – this smoothes and enhances the overall strategy return.

Here is how I have started to implement the idea (you can find the exact rules for the trend strategy here):
  • On a trend signal I enter a futures position (with the roll yield carry aligned) with my initial risk level defined by the strategy’s moving average exit: the average loss is calculated to be close to 0,33% NAV (my current capital) by using volatility based position sizing.
  • I overlay the trend position by selling the same amount of futures options (call for long and put for short positions), once it shows a profit of about 1% NAV – this equals a move of about 3x the average daily range and implies a breakeven stop point has been reached (about 60% of my positions reach that point).
  • I choose an option strike price out-of-the money. As a rule of thumb I want to see the following optimal profile:
  1. My strike price will give the underlying position an additional profit of about 0,5% NAV in case the option is exercised – it is about 1,5x the average daily range away.
  2. The premium received should amount to about 0,5% NAV – meaning I will see a profit of 2% (1,5% profit + 0,5% premium) of the value of my entire portfolio, if the strike price is exceeded at expiration without mean reversion taking place (this is a cap that I’m happy to realize during a parabolic price burst).
  3. Option expiration is about 1-2 months away – it depends on how close I can get to my desired parameters.
  4. The option can be covered at any time, if I want to roll the option forward or exit my underlying position – e.g. if it reaches a stop point.
Most of the time the trend stalls or mean-reverts temporarily and I can keep the premium and the original position to write another option a month later.

Often my stop loss is hit at breakeven and the option premium remains as the profit I make on the position.

Losing positions are stopped out before I ever write an option overlay.

This double carry method leads to a smoother basic return for the strategy and gives a behavioral incentive to ride the underlying trend for longer, if it materializes.

It cashes in on the observation that trend-following strategies have become a lot more difficult to run, because mean-reversion played a large role in the markets of recent years.


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