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Forex Stock Exchange Forum  » Forex and Stock Trading English Forum » Binary Options Trading School » Lower Exposure to Equity Risk Premium

Lower Exposure to Equity Risk Premium

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1attention Lower Exposure to Equity Risk Premium Mon Feb 29, 2016 4:20 pm

Yuri

Yuri
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We note that while profits should be earned from selling an expensive call, the delta (or equity sensitivity) of the long underlying short call portfolio is significantly less than 100% (even if the premium from the short call is reinvested into the strategy).

Assuming that equities are expected to earn more than the risk free rate (ie, have a positive equity risk premium), this lower delta can mean more money is lost by having a less equity-sensitive portfolio than is gained by selling expensive volatility. On average, call overwriting appears to be a successful strategy, and its success has meant that it is one of the most popular uses of trading options.

OVERWRITING WITH NEAR-DATED OPTIONS IS BEST

Near-dated options have the highest theta, so an investor earns the greatest carry from call overwriting with short-dated options. It is possible to overwrite with 12 one-month options in a year, as opposed to four three-month options or one 12-month option.

While overwriting with the shortest maturity possible has the highest returns on average, the strategy does have potentially higher risk. If a market rises one month, then retreats back to its original value by the end of the quarter, a one-month call overwriting strategy will have suffered a loss on the first call sold but a three-month overwriting strategy will not have had a call expire ITM.

However, overwriting with far-dated expiries is more likely to eliminate the equity risk premium the investor is trying to earn (as any outperformance above a certain level will be called away).
Figure 10. Call Overwriting SX5E with One-Month Calls of Different Strikes:


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