How To Survive A Volatility Crush

Covered call strategies are a favorite with options sellers because of their ability to earn consistent profits over time. In markets that climb or trade sideways, the call option premium provides the gains, and in falling markets, the same premium helps absorb the losses. Historically, this strategy has provided better returns with lower risk as compared to a long-only position.

However, traders and investors should be aware that there is a nightmare scenario for covered call sellers in which this normally successful strategy suffers losses for months in a row. In this scenario, called a Volatility Crush, options become underpriced but the market continues to fall, and the strategy loses money on virtually every transaction.

The returns from a covered call strategy come from two factors:  a market premium, and a volatility premium. The market premium is simply the tendency of the stock market to rise, which most of the time it does. (Difficult to believe sometimes.)  The volatility premium is the difference between the cost of buying options and the losses the seller takes, essentially income minus expenses.

What makes a covered call strategy so appealing is that when the market premium goes negative – in other words when the market falls - the volatility premium usually rises. This provides a kind of diversification and typically we see covered call portfolios recover extremely quickly after a market crash, much more so than long-only portfolios.

But in a Volatility Crush scenario the diversification properties vanish and both the market premium and the volatility premium stay negative. This situation is most likely to occur in conditions in which the market has fallen significantly, but investors have come to believe that the worst is over and that a new equilibrium has been reached with lower risk and moderate upside. The VIX falls and options become cheap.

Unfortunately for options sellers, the conventional wisdom is proven wrong, and the market still has two or three more corrections and rallies to go through. In each correction, the covered call strategy suffers sharp losses, and then in the ensuing rally, the gains are called away. The collected premiums fall far short of the losses taken, and the covered call strategy finds itself in a worse situation than the equivalent long-only position.

Option mispricing can occur because of simple forecasting error – predicting volatility is probably the hardest job on Wall Street. But it can also be the result of a collective rush to hedged strategies. In 2002, in the depths of the dot com crash, the CBOE introduced the BXM (Buy-Write) index and options selling strategies became much more popular and the inevitable result was an oversupply.

The first step in surviving a Volatility Crush is to recognize it. More than perhaps any other index, the VIX trades on emotion, and if it seems too low then it is critical to exercise judgment rather than to just stick with a pre-defined strategy. It helps to compare the implied volatility of short-term options with that of longer-term options, as these are less likely to be mispriced. (This is a good reason to sell a mix of both short-term and long-term options in a covered call strategy.)

And there is an upside to a Volatility Crush. In a low-VIX environment both speculation and hedging become cheaper. This is the time to cheaply hedge a long portfolio and lock in price protection while maintaining market upside. Or short the market but hold a now-cheaper call option for insurance against the inevitable squeeze.

Finally, remember that a Volatility Crush is self-correcting and that inevitably after several months of losses option sellers will demand much higher premiums, sending the VIX skyrocketing. While this can be frightening, especially if it happens right after a major correction, historically this is in fact the best time to initiate a covered call strategy and earn those juicy premiums while waiting for the market to recover.

Tristan Yates is the author of the book Enhanced Indexing Strategies and his articles and research on investing have been distributed through Yahoo! Finance, Forbes, MSN, Investopedia, Kiplinger, and Futures & Options Trader and cited in the Wall Street Journal and Globe & Mail. He can be reached at tristan@indexroll.com.