Practical Applications of Using the Volatility Risk Premium to Mitigate the Next Financial Crisis

Practical Applications Summary In Using the Volatility Risk Premium to Mitigate the Next Financial Crisis, from the Winter 2019 issue of the The Journal of Wealth Management, author Wei Ge (of Parametric Portfolio Associates LLC in Minneapolis) offers a new way to protect investment portfolios. The stock market has experienced a 10-year boom, and some investors expect a major bust soon. Ge suggests such investors adopt a volatility risk premium (VRP) strategy of writing options. One aspect of such a strategy involves writing put options. Writing puts with strike prices below current market prices lets VRP investors make money up front—and also limits their potential losses, since the stock prices must drop below the strike prices before the option writer must pay for an option holder’s shares. Ge demonstrates that portfolios using this strategy can perform well over the long term and would have lost far less than a pure stock portfolio during the financial crises between 1998 and 2011. Therefore, investors may wish to consider adopting such a strategy to protect themselves from losses. TOPICS: Analysis of individual factors/risk premia, financial crises and financial market history, performance measurement