March 9, 2019 marked the 10th anniversary of the low on the S&P 500 during the Global Financial Crisis. That signaled the beginning of one of the greatest decades for risk-adjusted return on record for the index, during which it posted an annualized return of 16.7%. Despite that performance, over the same period many market-neutral or non-directional index option strategies lagged what might have been expected of them relative to their historical results. This raises an obvious question: What changed during 2009 – 2019 compared with earlier periods?
Setting aside broader macro- and microeconomic relationships that drive markets over the long term, whether our non-directional index option writing strategies (index strangles and iron condors) are successful often boils down simply to maintaining the “odds” in one’s favor. The one big long-term assumption we make is that index option markets are continually seeking to “weigh”, or price, the odds of up-market returns (which benefit call options) versus down-market returns (which benefit put options).
We like to characterize a call option as a form of lottery ticket and a put option as a form of insurance contract. In short, markets shouldn’t allow investors to profit systematically from buying insurance or from buying lottery tickets. However, over the past few years, it appears that investors might have been able repeatedly to win the monthly S&P 500 sweepstakes.
It’s as if the CBOE S&P 500 Volatility Index (VIX), often called the “fear index”, has instead become the “greed index”. Figure 1 illustrates the tendency for the S&P 500 to appreciate when VIX is high. Historically, the VIX index has not been a predictor of the direction of the market. But over the last eight years, when the VIX has been high the market has tended to go up over the subsequent 20 days.
Figure 1. Has the “fear index” become the “greed index”?
CBOE S&P 500 Volatility Index levels and subsequent 20-day returns to the S&P 500 Index
Source: Bloomberg, CBOE.
Anyone who has navigated across long distances knows how small angle differences can result in significant deviations from the intended course. In the case of S&P 500 index options, the change in the return distribution of the S&P 500 has led to a historically unprecedented period of call-buying profitability—in other words, serial sweepstakes winners.
By netting the S&P 500 exposure from the CBOE S&P 500 30-Delta BuyWrite we can illustrate the success of systematically selling call options on the S&P 500 over the last eight years. Figure 2 illustrates that buying out-of-the-money call options has made an unprecedented amount of money, which accounts for the struggles of non-directional option strategies that sell call options either to source additional option premia, or to hedge short put-option exposures such as those generated by strangles and iron condors. Since March 2011, 30-delta monthly call options have been profitable in 55% of the months. By contrast, between June 1986 and February 2018 the success rate was only 34%. (Delta is the measure of an option price’s sensitivity to the price movements of its underlying market or security: if the underlying appreciates by $1, a 30-delta call option would be expected to appreciate by $0.30.)
Figure 2. Buying call options has been abnormally profitable over recent years
Rolling 12-month returns to buying out-of-the-money call options, 1987 – 2018
Source: Bloomberg, CBOE.
These results could potentially be explained if excessive call writing had led to artificially low call premiums (and therefore artificially high call-buying success), but the evidence does not support this. The option market has grown in a rational manner relative to the market capitalization of the S&P 500, and the market mix of call and put options has remained relatively stable over time, with calls representing 30 – 40% of that mix over the past 15 years.
It’s next to impossible to know anything with certainty in option markets, but we are fairly confident that investors cannot keep winning the monthly S&P 500 call-buying sweepstakes at their recent abnormally high success rate. The “fear index” may have become a “greed index” over the past decade, but it may be dangerous to keep on betting against the re-emergence of its true nature.