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The conventional wisdom in options trading – that equity index options are priced at a premium due to demand from investors seeking portfolio insurance – is facing increasing scrutiny as the volatility risk premium has unexpectedly fallen to zero since the onset of the Covid-19 pandemic. This shift presents a critically important challenge for investors accustomed to profiting from this premium, demanding a more sophisticated approach to options trading.
The Erosion of a Long-Held Belief
For years, options traders have operated under the assumption that options are consistently overpriced, reflecting the cost of hedging against potential market downturns. This difference between the implied volatility of an option and the realized volatility of the underlying asset is known as the volatility risk premium. However, recent market dynamics have disrupted this established pattern.
“As the market turmoil of the Covid pandemic, the average short-term risk premium embedded in S&P 500 volatility has fallen to zero,” one analyst noted. This unprecedented decline suggests a essential change in market perception and risk appetite.
Implications for Volatility Investors
The disappearance of the volatility risk premium forces investors to re-evaluate their strategies. Simply selling volatility, a historically profitable trade, is no longer a reliable source of income. Investors will now need to work harder and smarter to capture value in the options market.
Capstone,a firm specializing in volatility trading,suggests that a more nuanced understanding of market dynamics and a willingness to adapt are crucial for success. This may involve employing more complex trading strategies, focusing on relative value trades, or identifying pockets of mispricing that still exist within the options landscape.
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The changing landscape of the volatility risk premium signals a new era for options investors, one that demands greater skill, adaptability, and a willingness to challenge conventional wisdom.
