(Bloomberg) -- In the telling of Scott Maidel, a 20-year volatility pro, it’s official: the options-selling boom across Wall Street has now become too popular for its own good.
Retail and institutional crowds are pouring into funds that go all-in on stock derivatives to generate steady income on autopilot, day in and day out. But this now-$100 billion frenzy — part of the broader short-volatility trade — is whittling down once-lucrative returns, creating fresh wrinkles in the options landscape that specialist hedge fund managers like Maidel are racing to exploit.
“The problem is pricing has materially changed,” said Maidel, the head of hedge-fund business at $2 billion volatility shop QVR Advisors. “And because of that, those strategies just don’t look attractive anymore,” he said, referring to the craze for call-writing funds that sell bullish contracts en masse while taking long stock positions along the way.
San Francisco-based QVR started offering clients a strategy this year to capitalize on the constant wave of options selling from the likes of $37 billion JPMorgan Equity Premium Income ETF (JEPI), which has been dubbed a market whale because of its sheer size.
The JEPI strategy, known as overwriting, typically works best when the market stays calm or sells off, allowing a call seller to walk away with the premium when the bullish contract expires worthless. QVR takes a different route. In one example, it combines a long equity exposure, with a so-called convexity alpha wager that buys up cheap derivatives and may pay off when market volatility rises more than expected.
QVR claims the allocation method has consistently outperformed the likes of JEPI in backtests and is touting it to those clients looking for alternatives to traditional derivative-powered funds.
“We’re looking to do generally the exact opposite of the herd mentality,” said Maidel.
That may be easier said than done. Trading patterns are hard to divine at the best of times in the increasingly complex derivatives marketplace — with option-selling funds just one player among many — challenging strategies that seek to exploit trading flows from competitor products. Meanwhile, the JPMorgan ETF in question proved its mettle in the 2022 bear market, cushioning the S&P 500’s plunge in part thanks to its income-generating overlay.
But one thing is clear: Buyers keep plunging in. By the tally of Morningstar Inc., derivative-income funds have seen their assets quadruple since 2021, reaching a record $100 billion.
The way Maidel sees it, those strategies rely on option contracts tied to stocks or indexes to meet a desired yield — a process that’s typically repeated on a regular basis, with insufficient consideration given to the now-depressed prices of the derivatives caused by incessant supply.
As the biggest such player in the ETF world, JPMorgan says its options-powered funds including JEPI are actively managed, whether it’s picking stocks, selecting specific derivatives, and more. While call writing is part of the investing style, it’s a dynamic allocation through and through, rather than a mechanical process.
“Our managers are some of the most experienced options managers in the industry and these products are the most in-demand active ETFs in the world,” a JPMorgan spokesperson said in an email.
While the shifting economics of the trade may be debatable, the relentless demand is not. Since JEPI’s launch in 2020, Wall Street firms have expanded options-enhanced offerings with a vast array of return and leverage profiles, riding everything from Big Tech companies to index-linked contracts with a maturity of less than 24 hours.
There are some skeptics. In a paper last year, quant veteran Roni Israelov said buying these kind of funds for the express purpose of pocketing extra money is a mistake. That’s because gains can be eaten up by losses connected to the very options that traders were counting on to buttress returns.
Take the Cboe S&P 500 BuyWrite Index, a benchmark for the fortunes of the call-selling strategy. From 1986 through 2009, it beat the market 57% of the time annually, with half of the outperformance occurring when equities broadly went up. Since then, the win rate has fallen by half, all happening in a flat or down market.
Many factors have contributed to a drop in profits for those option sellers betting market prices will rise less than anticipated — something call-writing styles are effectively banking on. The biggest reason: The resilient US economy and a now-friendly Federal Reserve are helping to unleash risk appetite and fueling equity indexes to records.
Still to Dagney Maseda, a portfolio manager at SSI Investment Management, the options-income funds are too small to wield a meaningful impact on the broader market. That said, her firm has recently shied away from selling calls in its convertible-arbitrage strategy due to unappealing pricing.
“We just haven’t been willing to sell calls at those levels,” she said.
Maidel — like others in the space — remains steadfast in his conviction that the mechanistic selling of calls is too crowded to deliver lucrative returns ahead. One gauge of the profit potential, known as volatility risk premium, has been cut by half over time and at times turned negative for contracts tied to the S&P 500, QVR data shows.
“Derivatives are manufactured risk,” said Maidel. “There can be plenty of liquidity at terrible pricing for one side or the other.”
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