Low Volatility Makes Chasing Yield Risky

In the current low-volatility, low-yield environment, investors are attempting to recoup lost revenue by betting that things will stay calm. This according to a recent article in The Wall Street Journal that says investors are “desperate to sell insurance” in the form of options to earn whatever premiums they can.

Buyers of options insulate themselves against price swings while sellers are paid premiums as compensation for the risk of those swings. “Selling lots of options against unlikely events can generate a steady stream of income” which is enticing to yield-starved investors. The logic is illustrated through the example of home insurance: “Because most insured houses don’t burn down, the premiums homeowners pay compensate the expenses for the insurer when a few of them do.” Therefore, premiums must be high enough (compared to the frequency of fires) to deliver revenue.

Right now, the “premiums” are not very attractive and, if they continue to shrink, investors could face significant losses. The following chart highlights the narrowing gap between implied and historical volatility (to extend the metaphor, the variance between premiums paid and the frequency of actual house fires):

According to analysts at Bank of America Merrill Lynch, implied volatility is low because there is a glut of option sellers “out to collect whatever premiums they can.” The analysts argue, however, that while selling these contracts can be profitable under volatile market conditions, “doing so at current levels exposes investors to highly asymmetric risks.”

Uncertainty around the timing of a rate hike and the impending election are cited as factors that could cause a spike in volatility and force investors to sell assets to cover losses, “in turn driving volatility up and triggering more losses.”

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