Morningstar Advisor - Spring 2008 - 28

Gray Matters options become more valuable, just as I discussed when explaining implied volatility. Reversing that logic, if time passes and the stock price doesn’t move, the value of an option falls because it has less time to expiration and less time for the stock to move. The width of the distribution is implied volatility, and the movement of the stock is realized volatility. So, if we sell options, the stock price doesn’t move, and the option price falls, and we realize income because implied volatility exceeded realized volatility. By selling an option at the beginning of a period and repurchasing it later, we can translate this price change into cash flow. Stock Price at Expiration investments. Importantly, unlike stock prices, volatility cannot rise indefinitely or stock prices would all swing between zero and infinity. Similarly, volatility can never fall to zero or stock prices would become perfectly stable. Therefore, volatility is mean reverting, and over time, the long-term return to implied volatility will be limited to the spread between implied and realized volatility. Given that selling options has some of the characteristics of an insurance product, one would expect a slight premium to accrue to the options seller. Anecdotal data support this slight premium to the option seller over time, although the data sets available don’t include the crash of 1987, which may significantly bias the data in favor of implied volatility exceeding realized volatility. In short, from both a theoretical standpoint and from empirical data, there is not a clear and material long-term return to passive option strategies of either selling or buying implied volatility, but there could be some positive return over time, and there could be benefits from a diversification effect. How Implied Volatility Could Fit into Portfolios Finally, implied volatility can be used as an additional alpha-generating tool for active management. At the individual stock level, company fundamentals can be used to estimate mispriced implied volatility just as they can to estimate mispriced stocks. The value of a stock is equal to the expected value of a probability distribution of the outcomes for that stock. Therefore, much of the work that goes into estimating the expected value of the probability distribution (valuing the stock) can also be applied to estimating the probability distribution of potential outcomes, and thereby identifying probability distributions that don’t match fundamental estimates. Just as stock prices that don’t match fundamental value represent alpha-generating opportunities, probability distributions that don’t match potential distributions of outcomes represent potential investment opportunities. Implied Volatility Realized Figure E: The difference between stock price at expiration and strike price is above the value of the option. As a simple example, we can see that large stock movements in either direction by expiration would mean the options were undervalued at the beginning of the period, or realized volatility exceeded implied volatility. In figure E, the difference between the stock price at expiration and the strike price is far above the value of the option at the beginning of the time period. If the stock price moves by expiration by more than the option price at the beginning of the time period, we can say that realized volatility exceeds implied volatility. It is also possible to sell and buy combinations of options on a continuous basis as the stock price moves to capture as much as possible of the difference between implied and realized volatility, but understanding the concept of implied-versusrealized volatility is sufficient for understanding implied volatility’s role as an asset class. The upshot is that implied versus realized volatility is the measure of returns to options In practice, there are passively managed investment vehicles that allow investors to mix volatility investments into their portfolios. For example, a series of indexes exists that buy major equity indexes such as the S&P 500 and then employ passive options strategies such as selling covered calls on the indexes, and repeats the process with a regular frequency. These indexes have shown similar returns to the stock market on average, but with lower option index volatility. However, these products aren’t pure investments in volatility, because they are hybrid products that retain exposure to the absolute level of the underlying index value while harvesting volatility from one direction or the other. There are ways to invest in futures on implied volatility of major indexes, but these function more as an insurance product than as a longterm investment vehicle, spiking in value during times of panic and returning to normal as the markets calm. Implied volatility is largely independent from stock price, and volatility-muting benefits of its slight negative correlation with stock prices could lower the volatility of a portfolio. Combining the volatility-muting characteristics with the potential of insurance-premium-like returns and the potential for generating incremental alpha in an active portfolio leads us to acknowledge volatility as a unique asset class. K As Morningstar’s derivatives investing strategist, Philip Guziec, CFA, leads Morningstar’s option investment research. Morningstar takes a fundamental approach to options investing, as opposed to trading approach based on “technical” analysis. To learn more about Morningstar’s options coverage, and how it can help you use options in your practice, go online to the Morningstar Options Home Page at http://www.morningstar.com/Cover/ Options.aspx. The articles “Visualizing Option Opportunities,” “The Morningstar Approach to Options,” and “The Morningstar Option Strategy Map” should be particularly helpful. 28 Morningstar Advisor Spring 2008

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Morningstar Advisor - Spring 2008

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