As we have explored in prior blogs, option pricing models involve a series of inputs, commonly referred to as the “Greeks.” Each Greek measures an option’s price sensitivity to a different financial variable. Vega is a crucial Greek to understand, but potentially more important than understanding vega, is understanding what vega measures.
Vega measures an option’s sensitivity to volatility, and, with a firm understanding of vega and volatility, investors may be able to examine the profitability of volatility strategies through a new lens. For the examples in this blog, we will take a look at short vega strategies - specifically covered calls.
First, let’s back up and examine how volatility is calculated.
What does it mean for an asset to be volatile? I’m sure we can all roughly describe it: TSLA is more volatile than JNJ. Volatility as a metric reflects the magnitude at which a stock’s price moves over time. More volatile stocks have moves of greater magnitude, and vice versa. But how do we quantify volatility? Let’s take a closer look at TSLA versus JNJ.
Below we have the price performance of JNJ and TSLA over the last year. The outcome of returns is much wider for TSLA than it is for JNJ.
To compute volatility, we first compare each stock’s distribution of daily returns. Much like many occurrences in life (shoe sizes, the birthweight of babies, ACT scores), stock returns generally follow a normal distribution. For those that either did not take statistics, have forgotten, or slept through class, we’ll conduct a brief overview. The chart below depicts a normal distribution. It can be wider and flatter, or narrower and taller, but a couple key factors always remain true. Firstly, the normal distribution will be centered around a mean (μ). Secondly, the standard deviation (σ) measures how compactly (smaller σ) or widely (larger σ) observations are clustered around the mean.
Source: ztable.net
Bringing this back to equities, the wider the distribution of equity returns, the more volatile the stock. Let’s take a look at the return distribution of JNJ and TSLA. To do so we will take each stock’s daily percent performance from the above chart and plot it on a histogram.
While these charts both follow a normal distribution, the distribution of returns for TSLA is much wider. The standard deviation of JNJ’s daily performance over the last year was 1.04%, versus TSLA’s standard deviation of 4.04%. How does measuring standard deviation fit into volatility? Realized volatility is a measure of standard deviation, annualized based on the standard deviation’s return period.
Let’s solve it. We can use these standard deviations to determine the realized volatility of each underlier using the below formula. We take the standard deviation of returns (still denoted as σ) and multiply it by the square root of the return period (in this case, daily trading days).
Realized Volatility = σ × √T
JNJ = 1.04% x √252 = 16.50%
TSLA = 4.04% x √252 = 64.13%
This quantifiably tells us that TSLA experienced greater volatility in the last year than JNJ did. It also yields a simple pattern: a wider standard deviation equates to a higher volatility, and vice versa.
Our TSLA/JNJ analysis estimated realized volatility, not implied volatility. However, as mentioned earlier, vega and options are priced based on implied volatility.
Implied volatility is a measurement of how much the market predicts an asset will move in the future and is derived from a particular options contract. Unlike realized volatility, implied volatility is not observable in the market: it is implied from existing prices and strikes of options. Implied volatility levels can also be impacted by supply/demand imbalances that change option pricing. This tells us a very important usage of implied volatility: as a gauge of market sentiment.
Each option has its own implied volatility level. This is why stocks have a single realized volatility level for a trailing time-frame, but an entire implied volatility surface for a forward-looking tenor. An example is shown below.
This curve is commonly called a volatility smile. It captures the implied volatility levels at each strike (100% = at-the-money) for one tenor at a specific moment in time. These curves are called “smiles” as they have a consistent shape across all equities: near-to-the-money options have the lowest implied volatility levels and wingy (far out-of-the-money) options have the highest volatility. This should logically make sense, as more volatility would need to be observed for a stock to trade either 50% higher or lower versus remaining flat. While there can be deviations from the “smile” pattern, it generally holds to be true.
Traders will use volatility curves in many ways. One example is to plot the same tenor over multiple points in history. This shows how market expectations for future stock movements change over time.
Vega, as mentioned earlier, tells us the relationship between an option’s price and its implied volatility. It tells us how much an option’s price will move for a 1% change in the underlying asset’s implied volatility.
While volatility is indifferent to direction (i.e. call vs. puts), vega is not. An option buyer will always be long vega: an increase in implied volatility will result in an appreciation to their position, and vice versa. An option seller will always be short vega: an increase in implied volatility will result in a negative mark to their position and vice versa.
|
|
Put |
Call |
|
Short |
Negative Vega |
Negative Vega |
|
Long |
Positive Vega |
Positive Vega |
Purchasing a call option is a simple example of a long vega strategy. As the underlying asset moves with greater magnitude, the call option is more likely to move in-the-money and the owner's value will appreciate. Another example of a long vega position is purchasing a put option.
Writing (selling) a call option is an example of a short vega strategy. Call sellers benefit from selling high levels of volatility. However, they are hurt by increases to volatility once their short positions are in place, as their cost to buy-back or close their short position gets more expensive.
Call writing is used as part of a covered call strategy, and therefore can be evaluated as a short vega strategy. This directionality is evident in the below payout chart for a covered call strategy. The short call option payout is the highest when the underlying stock remains flat (i.e. volatility remains low).
Covered Call Strategy Payout Illustration
We can holistically bring all these volatility concepts together to evaluate the success of a covered call strategy.
As discussed, call writing (call selling) is short vega as the strategy sells volatility to collect premium. Meanwhile, implied volatility is the forward-looking level of an asset’s volatility predicted from option markets. Realized volatility tells us what the actual historical volatility was for that same asset. In aggregate, this information yields a relatively simple formula. For a short vega strategy to be successful, volatility should realize at or below implied levels.
The Roundhill Ether Covered Call Strategy ETF (YETH) may present a good graphical representation of this concept at work. You can see the timeframes in the charts below where out/under performance shifts based on the volatility. In aggregate, ether* realized volatility has averaged below implied, which potentially bodes well for YETH’s performance. This chart also flags the absolute level of implied volatility of ether* (averaging in the low-70s), which generates a very high premium.
If volatility were to realize above implied, it could indicate that the underlying stock is trading higher than the short call strike and the option position is marking negative. This negative mark then eats away at the premium collected from selling the initial call in the strategy. In this case, we would expect for holders of the underlying asset to benefit greater than those who capped their upside by writing calls. TSLA is an excellent example of this phenomenon, as its volatility has realized well above implied over the last year. Below are charts comparing both historical implied vs realized volatility and price performance of a covered call ETF (TSLY) vs its benchmark.
It is not uncommon for stocks to experience periods of realized volatility above implied, but it is during those periods that strike selection of covered call strategies becomes critical to success.
Short vega strategies on volatile assets, can prove to be very profitable when implemented successfully. However, they are accompanied by more risk than those on lower volatility assets, such as a broad market index, and require more strategic active management. The formula to a positive profit is never as simple as choosing one option’s underlier, strike, tenor, implied volatility level, and target premium. Active managers must deal with all of these moving variables at once and make risk-appropriate decisions when selling volatility.
When selling options, it is easy to get tempted by high premiums. Don’t forget: It is not only the magnitude of volatility that determines the success of a covered call strategy, but also the interrelationship between implied and realized volatility. Evaluating volatility levels and vega sensitivity are important considerations when trading a profitable options strategy.
Options are an invaluable tool for generating income and gaining leverage when traded effectively, and investors should do their homework before making investment decisions.
The Fund does not invest directly in ether. The Fund does not invest in, or seek direct exposure to, the current “spot” or cash price of ether. Investors seeking direct exposure to the price of ether should consider an investment other than the Fund. The fund seeks to provide exposure to the price return of an exchange-traded fund that invests principally in ether futures contracts (the “Ether Futures ETF”). The fund is not suitable for all investors and involves a high degree of risk.
The holdings of YETH can be found on the YETH webpage under the Holdings tab (https://www.roundhillinvestments.com/etf/yeth/).
Investors should consider the investment objectives, risks, charges, and expenses carefully before investing. For a prospectus or summary prospectus, if available, with this and other information about the Fund, please call 1-855-561-5728 or visit our website https://www.roundhillinvestments.com/etf/YETH. Read the prospectus or summary prospectus carefully before investing.
TSLY Disclosures
YieldMax ETFs LLC is the ETF sponsor. The Fund’s investment adviser is Tidal Investments, LLC (the “Adviser”).
Fund holdings and sector allocations are subject to change at any time and should not be considered recommendations to buy or sell any security.
The Funds’ investment objectives, risks, charges, and expenses must be considered carefully before investing. The prospectus contain this and other important information about the investment company. Please read carefully before investing. A hard copy of the prospectuses can be found at https://www.yieldmaxetfs.com/our-etfs/tsly/ or calling (866) 864-3968.
Past performance is no guarantee of future results. High ratings does not assure favorable performance.
EETH Disclosures
The Fund is advised by ProShares Advisors.
Fund holdings and sector allocations are subject to change at any time and should not be considered recommendations to buy or sell any security.
The Funds’ investment objectives, risks, charges, and expenses must be considered carefully before investing. The prospectus contain this and other important information about the investment company. Please read carefully before investing. A hard copy of the prospectuses can be found at https://www.proshares.com/our-etfs/strategic/eeth or calling (866)-776-5125.
Past performance is no guarantee of future results. High ratings does not assure favorable performance.
All investing involves risk, including the risk of loss of principal. There is no guarantee the investment strategy will be successful. For a detailed list of fund risks see the prospectus.
Ether Futures ETF Risks. The Ether Futures ETFs do not invest directly in ether. Accordingly, the performance of an Ether Futures ETF should not be expected to match the performance of ether. The Fund will have significant exposure to an Ether Futures ETF through its options positions that utilize an Ether Futures ETF as the reference asset.
Ether Risk. Ether is a relatively new innovation and the market for ether is subject to rapid price swings, changes and uncertainty. The further development of the Ethereum network and the acceptance and use of ether are subject to a variety of factors that are difficult to evaluate. The slowing, stopping or reversing of the development of the Ethereum network or the acceptance of ether may adversely affect the price of ether. Ether is subject to the risk of fraud, theft, manipulation or security failures, operational or other problems that impact the digital asset trading venues on which ether trades. The Ethereum blockchain, including the smart contracts running on the Ethereum blockchain, may contain flaws that can be exploited by hackers. A significant portion of ether is held by a small number of holders sometimes referred to as “whales.” Transactions of these holders may manipulate the price of ether.
Unlike the exchanges for more traditional assets, such as equity securities and futures contracts, ether and the digital asset trading venues on which it trades are largely unregulated or may be operating out of compliance with applicable regulation. As a result, individuals or groups may engage in fraud or market manipulation (including using social media to promote ether in a way that artificially increases the price of ether). Investors may be more exposed to the risk of theft, fraud and market manipulation than when investing in more traditional asset classes.
Ether Futures Risk. The market for ether futures contracts may be less developed, and potentially less liquid and more volatile, than more established futures markets. W
Futures Contract Risk. Risks of futures contracts include: (i) an imperfect correlation between the value of the futures contract and the underlying asset; (ii) possible lack of a liquid secondary market; (iii) the inability to close a futures contract when desired; (iv) losses caused by unanticipated market movements, which may be unlimited; (v) an obligation for an Ether Futures ETF to make daily cash payments to maintain its required margin, particularly at times when an Ether Futures ETF may have insufficient cash; and (vi) unfavorable execution prices from rapid selling. Unlike equities, which typically entitle the holder to a continuing stake in a corporation, futures contracts normally specify a certain date for settlement in cash based on the reference asset.
Covered Call Strategy Risk. A covered call strategy involves writing (selling) covered call options in return for the receipt of premiums. The seller of the option gives up the opportunity to benefit from price increases in the underlying instrument above the exercise price of the options, but continues to bear the risk of underlying instrument price declines. The premiums received from the options may not be sufficient to offset any losses sustained from underlying instrument price declines, over time. As a result, the risks associated with writing covered call options may be similar to the risks associated with writing put options. Exchanges may suspend the trading of options during periods of abnormal market volatility. Suspension of trading may mean that an option seller is unable to sell options at a time that may be desirable or advantageous to do.
Flex Options Risk. Trading FLEX Options involves risks different from, or possibly greater than, the risks associated with investing directly in securities. The Fund may experience losses from specific FLEX Option positions and certain FLEX Option positions may expire worthless. The FLEX Options are listed on an exchange; however, no one can guarantee that a liquid secondary trading market will exist for the FLEX Options. In the event that trading in the FLEX Options is limited or absent, the value of the Fund’s FLEX Options may decrease. In a less liquid market for the FLEX Options, liquidating the FLEX Options may require the payment of a premium (for written FLEX Options) or acceptance of a discounted price (for purchased FLEX Options) and may take longer to complete. A less liquid trading market may adversely impact the value of the FLEX Options and Fund shares and result in the Fund being unable to achieve its investment objective. Less liquidity in the trading of the Fund’s FLEX Options could have an impact on the prices paid or received by the Fund for the FLEX Options in connection with creations and redemptions of the Fund’s shares. Depending on the nature of this impact to pricing, the Fund may be forced to pay more for redemptions (or receive less for creations) than the price at which it currently values the FLEX Options. Such overpayment or under collection could reduce the Fund’s ability to achieve its investment objective. Additionally, in a less liquid market for the FLEX Options, the liquidation of a large number of options may more significantly impact the price. A less liquid trading market may adversely impact the value of the FLEX Options and the value of your investment. The trading in FLEX Options may be less deep and liquid than the market for certain other exchange-traded options, non-customized options or other securities.
Counterparty Risk. Fund transactions involving a counterparty are subject to the risk that the counterparty will not fulfill its obligation to the Fund. Counterparty risk may arise because of the counterparty’s financial condition (i.e., financial difficulties, bankruptcy, or insolvency), market activities and developments, or other reasons, whether foreseen or not. A counterparty’s inability to fulfill its obligation may result in significant financial loss to the Fund. The Fund may be unable to recover its investment from the counterparty or may obtain a limited recovery, and/or recovery may be delayed.
New Fund Risk. The fund is new and has a limited operating history.
Concentration Risk. The Fund may be susceptible to an increased risk of loss, including losses due to adverse events that affect the Fund’s investments more than the market as a whole, to the extent that the Fund’s investments are concentrated in investments that provide exposure to ether.
Non-Diversification Risk. As a “non-diversified” fund, the Fund may hold a smaller number of portfolio securities than many other funds. To the extent the Fund invests in a relatively small number of issuers, a decline in the market value of a particular security held by the Fund may affect its value more than if it invested in a larger number of issuers. The value of the Fund Shares may be more volatile than the values of shares of more diversified funds.
Roundhill Financial Inc. serves as the investment advisor. The Funds are distributed by Foreside Fund Services, LLC which is not affiliated with Roundhill Financial Inc., U.S. Bank, or any of their affiliates.
Glossary
Options: An option is a contract sold by one party to another that gives the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed upon price within a certain period or on a specific date.
Covered Call Strategy: A covered call strategy involves writing (selling) covered call options in return for the receipt of premiums. The seller of the option gives up the opportunity to benefit from price increases in the underlying instrument above the exercise price of the options, but continues to bear the risk of underlying instrument price declines.
Out-of-the-Money Options: Out-of-the-money options are options whose strike price is above the market price of the underlying asset.
Notional Exposure: The total value controlled by the Fund’s portfolio of option contracts. Notional exposure is calculated by multiplying the number of contracts held by the underlying index price and multiplying this product by the contract multiplier of $100.
Strike: The price at which an owner of a call (put) option has the right, but not the obligation, to purchase (sell) a stock for at the time of the option’s expiration.
Upside: Reflects the degree of upside potential that could be experienced by a reference asset, expressed as a percentage, before it moves above the strike price of an associated short call option. The likelihood that the short call option will be exercised effectively creates a cap on potential gains.
Expiration Date: The last date that an option contract is valid before it expires and ceases to exist.
Days to Expiry: The number of calendar days until an option contract’s expiration date.