Fun with Expensive Options

Harvesting risk premia is the core premise of most investment strategies, and quite intriguing is the volatility risk premium. It is well documented, and inherently makes sense. Because volatility skyrockets when bad things happen, buying volatility (e.g. in the form of put options or VIX calls) can insure a portfolio against crash risks. As with all insurance products, it is to be expected that this protection should not come for free – hence the insurer (the options seller) can count on getting paid a premium over time.

However, earning that premium by selling volatility is difficult and dangerous, because short volatility strategies are a prime example of negative skew strategies. They are often described as picking up pennies in front of a steamroller, as they are characterized by many small gains that are interspersed by few, but large losses. Infrequent crashes pose a serious risk, which is not easy to manage in practice.

But what if the premium paid for options becomes ridiculously high (as we often saw during the meme stock mania)? Might it turn the premise of short volatility strategies on its head, if we pick up gold bars instead of pennies? In this article, I construct a potential strategy that takes advantage of super-expensive options, while constraining risk to tolerable levels.

Selling a covered strangle

As with many option strategies, accurate historical data is hard to come by, so I’m basing my analysis on common sense assumptions and actual test executions. I want to make sure that my trade’s risk is always limited (no naked option selling) and not far out-of-whack with its profit potential, while selling both put and call options. I also believe that odds are more favorable betting on a sideways to up-market (with a very large safety cushion), because stocks tend to go up over time. Other than that, I will assume that I don’t know anything and results are going to be entirely unpredictable and random.

So here is what I plan to do: I will buy individual stocks and sell out-of-the-money calls and puts against them. This strategy is called a covered short strangle and if you google it, you will quickly find out that, when using mega-cap stocks, your maximum risk will be many multiples your potential profit (a typical negative skew profile). With a high win-rate this can still work very well, but it’s not what I’m after!

But, when you look at some of the more crazy names out there (e.g. meme stocks, biotech or crypto names), I found that, by selling OTM options with 1-3 months to expiration, it is possible to create a risk profile that risks around the price you pay for the stock at a maximum (if the company goes bankrupt during the trade), while potentially earning a slightly smaller profit than that. This implies that our strategy would need a win rate of around 60% or higher.

Essentially, the bet is that in an option-crazy world FOMO-driven traders will drive up demand and vastly overpay for call and put options on volatile stocks.

How to find expensive options

Key is to find some of the most expensive options with the highest implied volatility (IV) out there. I found a pretty nifty, free option screener at Market Chameleon that allows to sort options by implied straddle premium (a straddle is the same as a strangle, but uses at-the-money options). Once you look for a maximum of 100 days to expiration and stocks worth at least a couple of bucks with decent option volume, you will currently begin to find some good candidates yielding between 80% to 90% straddle premium (which translates to a strangle premium using relatively far-out-of-the-money options of 50-60%).

The nitty gritty details

OK, here are the details on a few current candidates, so we know what we are talking about (using actual prices those options traded at).

These are the parameters I use to get the risk profile in the table above:

Stock price: above $3 with a trial position size around $4000 (price x number of options x 100)
Options: OTM (10-15% OTM for calls; 20-30% for puts); 1-3 months to expiration; Combined premium for selling an equal number of puts and calls > 50% of stock price
Risk profile: Maximum risk is roughly equal to stock price (+/- 15% max); Maximum profit is 70-100% of stock price

What does this mean exactly? While forking over $4000 to buy the stock, I get paid $2000-2800 for selling an equal number of put and call options against it for a net expense of around $2000. This will be the approximate margin required for the trade, but I will need to keep another $2000-3000 in reserve to be able to cover the maximum loss, if the company goes bankrupt (While the stock is a complete write-off, I will then need to be able to pay for the assigned put option: I sell a cash secured put).
My maximum profit is capped and reached, if the stock trades above the call option strike at expiration (my stock is then called away and the put option expires worthless: the trade is closed automatically).

The AMC example below illustrates how big my margin of safety is to score a winning trade, due to the high premium: Every stock price above the break-even level at expiration, which is 40% below my entry price, will be a win! The P/L calculation is: Option premium received for call and put minus Stock entry price – exit price (capped by call strike) minus Put strike – exit price (in case the stock falls below the put strike and the option gets assigned).

So how likely is it that this is a successful strategy to harvest over-priced option premia?

These options are expensive for a reason

Of course, nothing comes for free and stocks like these are judged to be inherently high-risk to command such high option premia. The key question is: are those risks over-compensated for by the premium paid, or not?
We can be sure that such stocks will be highly volatile, carry elevated risk to go bankrupt, have a big risk to experience large price jumps at earnings or other news, and so on. So, in trying to assess potential probabilities for different outcomes (which are essentially unpredictable), I fall back to a common-sense approach that assumes a decidedly non-normal distribution with very fat tails and a flat middle (= less likely than normal to get a moderate outcome). By diversifying across time (different expirations) and several stocks, we can further reduce market crash and individual company risks, as well as create an income stream.

Common sense probabilities

My main argument is: We are likely being very well paid over time for taking on extreme risks on both sides (bankruptcy for selling put options; multiple X gains on the short call side), which cannot all occur simultaneously. By owning the stock, the unlimited risk profile of a short call option is hedged, and an extreme right tail event (= large price increase in the stock) will actually lead to a maximum profit for the trade. Only the left tail (bankruptcy, or other events causing a stock crash – within the life time of the option) is a real risk, which is limited by the stock falling to 0. (Due to the high premia paid, it is a very similar risk to buying a stock that then goes bankrupt or gaps down on bad news.)

Let’s break down the main scenarios that can possibly take place, assuming highly elevated tail risks, but otherwise a largely random outcome:

Non-event: Stock goes sideways and ends between option strikes (+/- 10-20% from entry)
Outcome: Profit of 40-70% of stock price, as options expire worthless and stock falls or rises marginally.
Probability: Option deltas equal the probability of ending in the money, which gives a rough estimate: ~30-40%
Volatile move: Stock gets cut in half or doubles
Outcome: Profit drops towards 0 as stock falls 40-50% or maximum profit as stock rises above call strike
Probability estimate: ~20% (10% for each event)
Highly volatile move: Stock falls 50-99% or gains by 2-3 standard deviations
Outcome: Loss of 0% to maximum loss or maximum profit (70-100% of stock price)
Probability estimate: ~20% (10% for each event)
Tail event: Company goes bankrupt or stock jumps by several standard deviations.
Outcome: Maximum loss (90-115% of stock price) or maximum profit
Probability estimate assuming elevated tail risk: ~25% (12,5% for each event)

What immediately jumps out at me is that profit probabilities are vastly higher, even if extreme outcomes in either direction happen the majority of the time – they add up to ~70-75%. Even if loss events occur more often than a right tail event (a non-random, left-tail skew; up to 40% of the time), the strategy still retains a healthy profitability over time, because a win-rate of 60% or above should suffice!

The left-tail skew would need to be quite extreme for this strategy to be a loser over time (though we should expect losses to cluster during bear markets). This positive expectation inherently makes sense, because the volatility risk premium to insure the riskiest of stocks should rationally be rather high.

Distribution of outcomes: The majority of outcomes lies in the green profit zone, as the stock can fall by 40-50% or rise infinitely to result in a profitable trade.

Follow–Up (April 13, 2023)

The highest risks the strategy faces are stocks going bankrupt or facing extreme event risks that lead to overnight gaps of 50% + (e.g. biotech stocks facing FDA decisions). During my test phase in the beginning of the year, I saw numerous examples of biotech stocks gapping (the majority of them down 60-80%), a banking crisis that saw bankruptcies from stocks mere days after they appeared on my highest option implied volatility screen, and so on.

The stocks with the very highest option premia are really, really risky.

While such a high-risk strategy is still likely to work over time, I would prefer to create a curated portfolio that I can write monthly options on again and again with fewer outliers and fewer changes in its composition. Therefore, I developed an adjusted screen to target a more moderate, second tier of highly risky stocks (defined by options with high IV) that are fairly well known and established: Blue Chip Speculative Stocks and High Quality MEME Stocks.

The main difference is that this new portfolio targets a lower strangle premium of around 10% monthly over a shorter time period (4-6 weeks to expiration), and aims to hold stocks long-term to write new strangles repeatedly.

I describe this in detail in a new post.

Please do your own due diligence before jumping in! This is not a backtest, merely a common sense estimate of the viability of such a strategy. We would now need to collect real world data. The only realistic way to do that (that I can see) is to use real trial trades with actual execution prices due to the large spreads in options for many of these stocks.

Good luck with your trading, and thank you for reading!

David

This is not financial advice.
These are my own views, as I may implement them in my own portfolio.
Please do your own due diligence!