Stress-Testing Volatility Risk Premium Harvesting Strategies Based on S&P 500 Index Options

Abstract

The volatility risk premium (VRP), commonly accessed by writing equity index options, can help investors enhance portfolio returns. Some investors, however, have an aversion to options selling, especially put options, because they fear significant losses in a financial crisis. This article examines this aversion by analyzing the performance of two VRP-harvesting strategies based on writing out-of-the-money S&P 500 Index options (the dedicated VRP and the overlay VRP constructs) in market distress and comparing them with the S&P 500 Index. All series are stress-tested with five historical crisis episodes in the last three decades and three additional extreme scenarios modeled after the worst stock market crashes in the past century. The analysis reveals that the VRP strategies can achieve their objective of outperforming the market and mitigating investors’ losses during financial distress. The performance of the VRP constructs in a crisis depends on two main factors: the beta of the VRP strategy and the speed of the market crash. This article concludes that investors’ aversion to option selling may be unjustified and they may benefit significantly from the VRP at all times, especially in today’s market, when expected returns from traditional assets are subdued.