What is Variance Risk Premium
Variance risk premium (VRP) is defined as the difference between Implied volatility and historic volatility measured over a defined period in the past. Capturing this risk premium can be done through options overwriting (selling calls or call spreads) or under writing (selling puts or put spreads).
Implied volatility usually exceeds historic volatility when there is an imbalance between supply and demand of options. These situations usually present good opportunities to capture the volatility premium whether it is on the call or put side and normally present themselves when there is uncertainty over the price outcome of a stock due to impending events, such as earnings reports, company related or even macro events.
It is during these circumstances that a trader needs to determine the risk/reward of overwriting or underwriting options. An eagerness to capture the volatility risk premium may result in an adverse outcome if the expected outcome leading to the event is not realized. To minimize the impact of such situations, technical analysis could be applied to provide the trader with an edge, as the example below will show.
Taking the case of Disney (DIS) prior to its earnings announcement on November 14, 2024, Implied volatility had begun to increase and on Nov 13 had doubled over its historic volatility. Clearly, the market had high expectations of Disney earnings, but what was the TA of the stock showing?
- DIS was trading above its 20-and 50-day SMAs with both SMAs pointing upward. It had just closed over its 200-day SMA on Nov 13th.
- Bollinger bands showed compression leading up to the 13th, with the bands expanding and prices tagging the upper band.
- Volume had been steadily improving leading to the 13th
- RSI was comfortably over 70%, indicating strong momentum
- PPO cross over had occurred during the prior week and supported a move higher
- On balance volume (OBV) was increasing with prices implying that the higher prices were supported by good volume
- ADX was rising, with DMI+ exceeding DMI-, indicating a strengthening trend
All in all, TA analysis of the daily DIS chart suggested that the stock had a bullish bias.
What sort of trades could be employed to capture the volatility risk premium assuming this bullish bias?
- Buying calls to capture a possible move higher. However, this would involve buying expensive calls and goes against the grain of buying low vol and selling high vol.
- Buy the outright stock with a stop below the buy price. This involves an initial capital outlay and a downside risk defined by the stop.
- Selling puts below the market price to capture the vol premium and risk managing this position through buying another put at a lower strike, should earnings disappoint.
Trade Example
Selecting the third option, we see its application through an actual trade below.
- A strike price of 96 was chosen for the short put as it indicated a premium of $1, a handsome premium for a put option 0.25 delta out of the money with two days to expiry as of Nov 13th.
- The thinking here is that if the earnings disappoint the following day, prices would at least find initial support at the 50-day moving average i.e; at 95. This level also served as the breakeven for the trade, given the $1 premium collected.
- Additionally, catastrophic loss protection was secured by buying a put option at a strike of 86 for $0.09, just in case. In the event, DIS reported earnings on Dec 14th that exceeded expectations and both the puts approached zero with one day to expiry.
Outcome
Over a two-day period a premium of $490 excluding brokerage commissions was captured by writing a put spread on DIS through capture of the volatility risk premium.
Conclusion
Such opportunities present themselves from time to time and by applying TA, chances of a favorable outcome can be improved. Feel free to contact me if you have any questions.
Sowmi Krishnamurthy CMT
SK Market Insights Ltd
