Option investing is a concept that use option strategies to generate stable and uncorrelated returns. Global Hedge Fund managers use such strategies to harvest Volatility Risk Premium (VRP).
VRP refers to a phenomenon that option implied volatility tends to exceed realised volatility of the underlying asset over time, thus creating a profit potential for the volatility seller.
Most of us tend to trade directionally using futures when stocks have hit price extremes. However, I prefer to trade these extreme using options. For one, it has higher “probability of profit” and secondly, the trade can still be profitable even if I am slightly wrong directionally.
But, how should we define “price extreme”? This is very subjective. Given the positive drift of the underlying, the threshold for me is a 3% weekly fall in the underlying asset and the strategy to harvest the volatility premium is to sell a 30-delta put option expiring next month.
Backtesting & Assumptions
To test this concept, I performed a quick backtesting using Python from Jan 2010 to June 2018 with the following assumptions:
- Backtesting assumes zero friction and trades were fully collateralized (meaning returns were calculated on notional value of contract and not on margin deployed for the trade).
- 30-delta strike levels were derived using India VIX.
- Trade was entered (in the next expiration month) on the following day of the week that recorded greater than 3% fall.
- Trade was left untouched and all statistics were recorded between entry and expiry levels.
Profit & Loss Distribution
Backtesting Results
Selling puts into weakness (measured by the percent moves) did yield a substantial profit with an average yield of 0.70% per trade.
The primary Indian stock index, the Nifty 50 fell more than 3% this week and there were only 30 instances in the past eight years where the benchmark Nifty Index recorded a fall of this magnitude. Thus, statistically the week of September 21, 2018 marks an important occurrence.
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