Why Selling Options Looks Profitable Until It Stops Being

Short options positions decay steadily in calm markets because of negative gamma, and the same convexity that funds the steady gains drives the loss.

Selling options collects a premium up front that shows up as a steady, small, positive profit and loss in most weeks, which makes the strategy look attractive on a track record built during calm markets. The same position is short gamma and short vega, so its exposure to a large or fast move grows exactly when the strategy needs it least, and the strategy’s own popularity can make that move larger once enough capital is positioned the same way.

A sold option decays in value every day the underlying stays inside a range wide enough to keep the position out of the money, and that decay shows up as a small, predictable credit to the position’s daily profit and loss. Because implied volatility has tended to sit above the volatility that subsequently realises, described in implied volatility compared with realised volatility, a short options book collects that gap period after period during any stretch where nothing unusual happens, producing a track record with a high proportion of winning days and low visible variance, the exact shape of return series that attracts capital looking for a steady source of income.

The position is short gamma, meaning its sensitivity to the underlying’s price itself changes as the underlying moves, and it changes in the worst possible direction: losses accelerate as the move against the position gets larger, while the profit on a calm day is capped at the premium already collected. A return series built from many small, capped gains and one large, uncapped loss can show an excellent daily win rate and a low daily standard deviation right up until the loss occurs, so neither of those two statistics, computed over a sample that has not yet included the tail event, describes the actual risk being carried, the same asymmetry that skew across strikes is pricing into…

The clearest documented illustration is the volatility spike of February 5, 2018, when the VIX index moved from the high teens to close to 37 within a single session, and VIX futures moved by even more given the leverage embedded in how those futures price relative to spot during a fast repricing. Exchange-traded products built to deliver short exposure to VIX futures lost more than 80 percent of their value that day, and the issuer of one of the largest such notes announced it would terminate the product shortly afterward, converting a position that had shown years of steady gains into a near-total loss in a single trading session.

Short-volatility products and strategies had grown to an estimated tens of billions of dollars in aggregate exposure by early 2018, and several of the largest were structured to rebalance daily, buying more VIX futures whenever the futures price rose, in order to maintain their targeted exposure. That rebalancing mechanic meant the spike itself created forced buying that pushed VIX futures prices higher still, which in turn forced more rebalancing, a feedback loop between the price move and the positioning built to track it that amplified the size of the spike beyond what the underlying equity market move alone would have produced.