Despite the fact that we have no listed options on cryptocurrencies yet (Feb 2018), it would be interesting to calculate their theoretical Fair Values. In fact, it is quite an easy task since we have a series of historical quotes of an underlying cryptocurrency.
According to the OptionSmile methodology, we just need to build a probability distribution of historical returns and then, for any given expiration/moneyness, calculate the probability of in-the-money expiration (Pitm) and conditional expected value (payoff) in such expirations (EVitm).
That is just a theoretical exercise, of course, without a practical application. Not only due to the absence of an opportunity to trade these contracts but also because of the huge diversity of market regimes that took place in the past for these assets. Combining together the prolonged periods of extreme uptrends and the following crashes will inevitably produce a mixed bag of regimes that will have quite a poor prediction power.
Nevertheless, it is still interesting to look at the results in comparison with the regular, more mature instruments like stocks and ETFs. Just for the sake of curiosity.
Covered Call strategy works great in downtrending or rangebound markets: short call legs have positive expected profit and decrease the overall portfolio volatility.
However, in the Bull Markets, it does not so look attractive, at the first glance: with uptrending price, the short call leg often expires in-the-money forcing the underlying security to be called out and not to participate in the market rise above the call strike. Overall, in bull markets, calls are underpriced on average and the short call strategies have negative expected profit.
This research is devoted to finding the answer to the question: can a Covered Call strategy be efficient in the Bull Market environment despite the fact that it has an expected profit less than a simple Buy&Hold of the underlying security.
The conclusion is yes, the Covered Call strategy, especially with calls in the ITM area, can be quite efficient due to the substantially lower volatility of returns and higher risk-adjusted performance. By means of leveraging, it is possible to achieve higher absolute return than with an outright Buy&Hold strategy while having the same risk level measured by standard deviation and maximum drawdowns.
There are various pieces of evidence exist confirming that put options on wide equity indices are permanently overpriced by the market. The excess demand for the long portfolio protection is believed to be the main reason for this.
This research conducted using the OptionSmile platform underpins that observation and confirms that a put options selling has abnormally high expected profit.
However, on the risk-adjusted basis, such a short put strategy does not look so attractive due to the high volatility of results and regular huge drawdowns: the Sharpe ratio of a put selling, even with limited risk (spread strategy), is not so attractive and does not differ significantly from the Sharpe ratio of the outright long position in the underlying security.
Therefore, that high profitability of puts should be considered as a volatility premium rather than a market inefficiency.
iPath S&P 500 VIX Short-Term Futures exchange-traded note (VXX), as many other similar volatility products, has been initially designed to provide an exposure to the volatility index on S&P500 – VIX. Being included in the long-term investment portfolio, this ETN was supposed to serve as a safety buffer during the market drops and, hence, should decrease the overall portfolio volatility enhancing the risk-adjusted return.
However, since VIX itself is just an index and is not tradable, VXX employs futures on VIX to replicate the desired exposure, and this changes the internal mechanics of this product completely. It demonstrates the positive dynamics only in the short-term – in times of volatility splashes, but during all other, more silent, periods, it is exposed to another very strong factor – volatility term structure. That phenomenon reflects the expectation of the market about the future VIX levels and is captured by the futures on VIX traded on the CBOE Futures Exchange (CFE). Most of the time, the VIX futures are in a contango (the near future price is lower than the further), and VXX constantly diminishes its value by the negative daily “roll yield”.
In this research, we have compared four strategies to exploit the constant downtrend in VXX: buying the inverse VIX ETN – XIV and buying the put options on VXX with different strikes (OTM, ITM, and ATM).
Long Put strategies look appealing due to the inherent downside protection that, theoretically, could lead to the superior risk-adjusted returns. However, the conclusion we have come is that both buying XIV and puts on VXX have almost the same performance measures by the Sharpe ratio, maximum drawdowns, and the shape of equity curves.
Covered Call is a popular strategy that is often considered as a source of additional income for a long-term equity investor. Writing OTM calls is supposed to be a conservative strategy an average investor can pursue to earn a supplementary gain in excess of the underlying assets return.
However, it turns out that the call overwriting against the major equity indices does not add any meaningful profit to the portfolio because almost all the premium collected from the short calls will eventually be lost in the form of not participating in the growth of the underlying security called-out in the cases of ITM expiration.
This research demonstrates that call options on equity indices are priced quite fairly on average (in the contrast to puts) and usually have expected profit/loss close to zero. Moreover, in the secular bull markets, they are mostly underpriced, and Covered Call imposes a drag on the portfolio performance.
Nevertheless, on a risk-adjusted basis, this strategy can be quite attractive, especially for the ITM calls selling.