Impacts of the Growing Consensus on Option Selling

Derivatives markets are dominated by end users, who manufacture risk to meet their specific needs and objectives. These players ultimately set market prices through supply-and-demand dynamics. However, when the scale of these flows becomes disproportionately large relative to the market size, they can significantly impact market prices and alter risk premiums. 
 
A prime example of this phenomenon is the current oversupply of option-selling strategies. This group has a considerable effect on implied volatility, thus influencing option pricing. We believe that this trend is causing a significant structural dislocation in the financial markets. 
 
How did we get here? 
 
Following the Global Financial Crisis (GFC), there was an increase in both retail and institutional demand for option-selling strategies as an "evergreen" asset class for income generation. Short volatility strategies were portrayed as defensive equity substitutes with lower volatility based on historical data analysis prior to GFC years, which later turned out to be false, especially after long periods without crises emboldening tail risk sellers. 
 
The shift from viewing benchmarks like Cboe BXM or PUT Indexes as “equity-like returns with lower volatility” pre-GFC to “equity-like risks with lower returns” post-GFC reflects how attractiveness fluctuates over time across all risk premiums. In derivatives markets, one can simply look at the price for evidence rather than relying solely on statistical estimates to determine whether there was a risk premium. 
 
Today's landscape 
 
Asset allocators today are categorizing traditional asset classes into various strategy categories such as tail hedging, long volatility, short volatility, or market neutral within the hedge fund space, dealing with general derivatives strategies including hedged equity or covered calls (Volatility Risk Premium, or VRP). The popularity of these prevalent strategies continues to rise due to their largely creative marketing spin, notwithstanding questions about short-volatility strategies from our perspective as derivative-based hedge fund managers. 
 
Common misconceptions 
 
There is widespread belief that covered call selling uses an investor's equity position to generate income. While it is true that this strategy can provide some yield, its value fluctuates with market volatility and cannot be relied upon as a consistent source of income. 
 
Another popular investment thesis is that options are systematically overpriced and should therefore be sold rather than bought. However, evidence suggests that short-term options have steadily become less expensive over time, contrary to the belief that they are always overvalued. 
 
Similarly, the notion of using option selling strategies for "defensive equity" or "hedged equity" has been widely accepted despite evidence showing these strategies do not inherently reduce risk but instead mirror equities' exposure in sharp market sell-offs. 
 
The persistence of these misconceptions can largely be attributed to creative marketing spins such as rebranding the Cboe BXM index from the S&P 500 total return benchmark to a split between T-Bills and the S&P 500 total return, thereby lowering the performance bar. Other examples include relabeling volatility selling strategies relative to the to the HFRXEH index as hedge fund substitutes that work until they fail miserably during periods of low cash rates. 
 
Impact on future returns 
 
With the increasing popularity of option-selling products comes an inevitable degradation in up-down capture for investable benchmarks like Cboe BXM and HFRXEH indexes due to oversupply-changing game dynamics. This poses a major problem for many investment managers, contributing to large structural dislocation by significantly impacting implied volatility, thus negatively affecting those relying on these types of strategies. 
 
Despite deteriorated opportunities, legacy firms continue to persist with existing programs due to business operation entrenchments, even though simple approaches pursued too many players, degrading returns and negatively impacting implied volatility. 
 
As derivatives-based hedge fund managers, however, we see this new expanding opportunity set differently, with different vantage points.