The Importance of Persistence
By Warun Kumar, Michael Davis, Brendan Finneran, and Bob Hofeman
Much of Rampart’s options trading is focused on extracting value from the Volatility Risk Premium, which is simply the premium that tends to be built into option prices (please see our prior publication, “Extracting Value from Volatility”). Rampart makes this capability accessible to clients in a number of ways, notably through the Virtus Rampart Enhanced Core Equity Fund (A: PDIAX; C: PGICX; I: PXIIX) and the Portable Yield Strategy (PYS) managed account program. One feature that sets Rampart’s strategy apart from others in the industry is the focus on shorter-term trades. We view this to be a significant contributor to performance stability and a positive client experience.
The Contemporary Options Market
Until recently, there were significant timing limitations to the implementation of any volatility trading strategy. For the first several decades of the modern U.S. listed derivatives market, S&P 500® Index options were available with expirations only on a monthly basis—specifically, the third Friday of each month. Over time, the frequency of available expirations increased. In 2005, it became possible to trade S&P 500 Index options with expirations on each Friday of the month. These options were thinly traded at first, but by 2013 it was not uncommon for these “weeklies” to constitute one third or more of daily trading volume in S&P 500 Index options. Most recently, in 2016, the CBOE introduced Wednesday and Monday expirations. As depicted in Figure 1, in June of 2017, the volume traded in these weekly expirations exceeded 40% of the entire S&P 500 Index options market.
Source: Bloomberg, CBOE, Rampart. Time period: 12/6/2005 – 6/23/2017
Taking Advantage: An Example
Rampart has been an active participant in the weekly options market since 2013, as we believe that we can produce more stable outcomes for our investors by accessing the volatility risk premium with greater frequency. To illustrate this concept in general terms, consider the following two scenarios involving a simple coin-toss game:
One year from today, two friends flip a coin once:
Heads: Roger gets $12 from Rafael
Tails: Roger pays $12 to Rafael
Every month for the next year, Roger and Rafael play the same game as above, but there are 12 flips and the stakes change:
Heads: Roger gets $1 from Rafael
Tails: Roger pays $1 to Rafael
Which is the more attractive game? There is an interesting difference in these two games—while the “return” is the same, the risk is not. Statistically speaking, the two games have the exact same expected value: zero (assuming the coin is fair—an important caveat). In Game One, the math for Roger is as follows: 0.5 times $12 plus 0.5 times -$12 equals zero. In Game Two, the math is the same, except that the stakes are $1 instead of $12, and the resulting zero is multiplied by 12 to account for the monthly trials. We can also quantify the risk of each game (and we will below) but our intuition is a more than adequate guide.
Consider Game One. While the statistical value of any one trial is zero, practically speaking, Roger will either earn or lose $12 each time the game is played. Depending on Roger’s capitalization, he may not be in the position to lose $12, even with the possibility of winning $12. If we say that Roger starts with $12 in his pocket, the first flip of the coin could put him out of business. Looking at Game Two, the risk analysis is quite different. For Roger to exhaust his initial $12 of capital by the end of the year, the coin would have to come up tails twelve consecutive times. The odds of this happening are one in 4096, or 0.02% of the time.
Another way to analyze these two games, and to quantify the risk differences, is to simulate multiple instances of each and derive the variance of the resulting sets. This sort of analysis is commonly known as a “Monte Carlo Simulation.” The setup is as follows:
Randomly generate either a one or a zero to simulate a coin flip. One corresponds to heads, zero to tails. Roger wins or loses $12 depending on the outcome. Repeat this process 5,000 times to generate a large set of trials.
Randomly generate either a one or a zero 12 times to simulate 12 monthly coin flips. Roger wins or loses $1 each month depending on the outcome. A sum of Roger’s wins and losses is tallied – this is his return for that year. Repeat this process 5,000 times to generate a large set of trials.
Once we have run these simulated games, we can compute aggregate statistics for all of the trials. As expected, the average value across all trials for both games is zero (in reality, even with 5,000 simulations, the value won’t be exactly zero, but it’s close). If we run the standard deviation, we get significant differences between the two games. The standard deviation for Game One is 12. This is not surprising, given that the data set is made up entirely of +$12s and -$12s.
For Game Two (twelve coin flips per year) the standard deviation of yearly outcomes is about 3.5. This result corresponds to the intuition we developed earlier—by increasing the number of trials, Roger is able to significantly reduce his risk for the same expected return.
At Rampart, this same principle applies to our option trading. By taking advantage of the increased availability of option expirations (more “coin flips” per year), we hope to provide a more consistent performance profile for investors. We can see this effect if we compare the performance track record of the Portable Yield Strategy (PYS) to the CBOE Iron Condor Index (“iron condor” is the industry name for the volatility trade used in PYS and the Virtus Rampart Enhanced Core Equity Fund). One of the key differences between these volatility trading strategies, which both use the same basic trade structure, is that PYS initiates a new trade every week while the CBOE Iron Condor Index initiates a new 1-month trade every month. In the language of our Roger and Rafael example, PYS plays the game 52 times a year, while the Index plays 12 times a year. This difference in approaches can be seen in the performance track record for each in Figure 2.
Source: Bloomberg, Rampart. Time period: 12/26/2013 – 6/30/2017. Performance is presented gross of management fees. Past performance does not guarantee future results.
Here we can clearly see how the increased trading frequency makes an enormous impact on the performance path. While it would be reasonable to expect both strategies to converge from time to time (although there are additional structural and investment difference between PYS and the Index aside from the number of trades per year), the PYS experience has been, over the past several years, considerably smoother.
While we have used the concept of a coin toss—which supposedly has 50/50 odds—as the proxy for our analysis, it is important to recognize that the volatility trade implemented in the Portable Yield Strategy and the Virtus Rampart Enhanced Core Equity Fund is not a simple coin flip. Rather than relying upon arbitrary heads or tails wagers, the strategy is grounded in years of research and practical investment experience. Every option trade that Rampart implements has a positive expected value at initiation. Since Rampart launched the strategy in managed account portfolios in December 2013, over 95% of trades have been successful. In other words, the “coin” we are tossing has historically been weighted in our favor. It is our firm belief that when faced with a positive expected value trade, it makes sense to implement it as often as possible.
Performance data quoted represents past results. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown. Investment return and principal value will fluctuate, so your shares, when redeemed, may be worth more or less than their original cost. Please visit virtus.com for performance data current to the most recent month end.
Equity Securities: The market price of equity securities may be adversely affected by financial market, industry, or issuer specific events. Focus on a particular style or on small or medium-sized companies may enhance that risk. Call/Put Spreads: Buying and selling call and put option spreads on the SPX Index risks the loss of the premium when buying, can limit upside participation and increase downside losses. Portfolio Turnover: The fund's principal investments strategies will result in a consistently high portfolio turnover rate. A higher portfolio turnover rate may indicate higher transaction costs and may result in higher taxes when fund shares are held in a taxable account. Fund of Funds: Because the fund can invest in other funds, it indirectly bears its proportionate share of the operating expenses and management fees of the underlying fund(s). Industry/Sector Concentration: A fund that focuses its investments in a particular industry or sector will be more sensitive to conditions that affect that industry or sector than a non-concentrated fund. Prospectus: For additional information on risks, please see the fund's prospectus.
Please carefully consider a Fund’s investment objectives, risks, charges, and expenses before investing. For this and other information about any Virtus mutual fund, contact your financial representative, call 1-800-243-4361, or visit Virtus.com for a prospectus or summary prospectus. Read it carefully before investing.
There are several factors to take into consideration when evaluating the risks of PYS:
- If the S&P 500® Index becomes more volatile, causing more of the short calls and puts to settle in-the-money, there will be a negative impact on performance.
- If liquidity and pricing transparency in the weekly expirations diminish, there could be negative impact on performance. In extreme situations, we may be unable to implement the strategy.
- Transaction costs could be significant in multi-leg options strategies, including spreads, as they involve multiple commission charges.
- If PYS is used as an overlay and the underlying portfolio is highly correlated with the S&P 500® Index, there may be times when the losses experienced in the underlying portfolio are exacerbated by PYS.
- Margin requirements for option writers are complicated and not the same for each type of underlying security. They are subject to change and can vary from brokerage firm to brokerage firm. As they have significant impact to the risk/reward profiles of each trade, writers of options (whether they be calls or puts alone or as part of multiple position strategies such as spreads, straddles, or strangles) should determine the applicable margin requirements from their brokerage firms and be sure that they are able to meet those requirements in case the market turns against them.
- Taxable clients should consult a tax adviser to determine how options transactions and any sales of underlying stock will affect their tax situation. Tax-exempt investors should ensure that counsel is comfortable that the strategy is allowed and, if not, what steps need to be implemented to amend the plan document.
- The investor should also confer with their custodian to ensure the full understanding of the options settlement process and collateralization requirements.
- There is no assurance that Rampart Investment Management will be successful in implementing its strategies (e.g., identifying or exploiting option pricing inefficiencies).