Nasdaq-100 Tail Hedge Monetization: Testing the Effectiveness of Implied Volatility Signals

STUDY SUMMARY

We explore the effects of an implied volatility-based monetization scheme on a laddered sell strategy on the Nasdaq-100 Index (NDX). The strategy holds 1, 2 and 3 month put options on NDX hit 20% out of the money. We buy new 3-month put options on every third Friday expiration, spending 10 basis points per month (1.2% per annum) of the total notional of the portfolio. We also analyze performance with a common long position in NDX to demonstrate the value of systematically monetizing options contracts to lock in gains from adverse market events. Specifically, when a monetization event occurs, the proceeds from the sale of put options are stored in an interest-bearing cash account until the following day, when the proceeds are first invested in a new put at 3 months and the rest in NDX. Implied volatility is referenced as 50 delta 1 year implied volatility and 50 delta 1 month implied volatility. The study period runs from January 1, 1997 to February 15, 2022.

In this study, we monetize one-third of the options position if the 1-year implied volatility exceeds a 35% threshold and sell the remaining two-thirds of the position if the 1-month implied volatility exceeds a 70% threshold.

RESULTS

We found that there was a significant benefit to including an implied volatility-based monetization system to reduce the impact of market declines. In our study, monetization served as an effective mechanism to take advantage of adverse market events. We found that the monetized strategy reduced annual volatility by 115 basis points while returns were only reduced by 2 basis points. On the other hand, the non-monetized strategy was effective in reducing risk, but at a significant cost since annual returns were lowered by 52 basis points.

As a stand-alone overlay (i.e. not including the underlying asset), the monetized strategy outperformed the non-monetized version on a cumulative basis. The non-monetized strategy achieved cumulative returns of -16.78% while the monetized strategy achieved cumulative returns of -8.77%. The maximum return over 1 month of the monetized strategy was 6.26% against only 1.89% in the non-monetized strategy.

The historical and simulated performance of the index is not necessarily indicative of future results. These products do not offer investment advice. The Company is not an investment adviser. The Company assumes no liability for any loss or damage of any kind resulting from the use of any or all of the Company’s products and the information contained therein.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

About Larry Noble

Check Also

Divergence turns volatility into massive market gains

[Editor’s note: “Divergence Transforms Volatility Into Massive Market Gains” was previously published in May 2022. …