Dynamic Call Option Overwrite Strategy for Volatility Risk
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Solution Overview
Problem
The existing buy-write strategy in financial markets may underperform during down markets, failing to provide adequate downside protection due to a 100% overwrite of call options, which limits upside potential and results in negative returns when implied volatility is low.
Innovation Solution
A rules-based approach that dynamically adjusts the proportion of call options written based on implied volatility levels, using volatility indices like VIX and VXN to determine the percentage of the portfolio to overwrite, allowing for greater participation in index gains during low volatility and providing a downside cushion during high volatility.
Engineering Contradictions & Design Principles
Engineering Contradiction Analysis
1Loss of energy
If 100% of call options are written in a buy-write strategy, then premium income is maximized, but upside potential is limited and downside protection fails during down markets
Solution Approach 1:
The patent applies dynamics by making the call option writing percentage variable rather than fixed at 100%. The system dynamically adjusts the overwrite percentage based on real-time volatility index levels, transitioning from a static buy-write strategy to an adaptive system that responds to changing market conditions. This resolves the contradiction by allowing the strategy to maximize premiums during low volatility while maintaining flexibility for downside protection during high volatility.
Solution Approach 2:
The patent changes the key parameter of call option overwrite percentage from a fixed value (100%) to a variable parameter determined by volatility index thresholds. By establishing different overwrite percentages corresponding to different volatility levels, the system optimizes premium income during low volatility periods while preserving capital during high volatility periods, thus resolving the contradiction between maximizing premiums and maintaining downside protection.
2Stability of the object's composition
If call options are written during low implied volatility, then the strategy provides stability, but premium income is low and upside gains are missed
Solution Approach 1:
The patent applies parameter changes by adjusting the call option overwrite percentage based on volatility index levels. During low implied volatility periods, the system reduces the overwrite percentage below 100%, allowing the portfolio to participate in upside gains while still collecting some premium income. This resolves the contradiction by optimizing the balance between stability and premium income according to prevailing volatility conditions.
3Reliability
If the buy-write strategy is used to reduce risk, then downside protection is provided, but the strategy underperforms during down markets
Solution Approach 1:
The patent applies dynamics by making the risk management approach adaptive rather than static. The system dynamically adjusts the degree of downside protection by varying the call option overwrite percentage based on volatility index levels. During high volatility periods, increased protection is provided; during low volatility periods, less protection is applied to avoid underperformance. This resolves the contradiction between providing reliable downside protection and maintaining strong return performance across different market conditions.
Data Source
AI summary
An active overlay strategy based on rule-based risk management is implemented by a computer implemented method. The method includes receiving a data value representing implied volatility of a market. The method also includes automatically generating an order to sell call options. The order includes a quantity of call options to sell, where the quantity is determined at least in part based on an evaluation of the data value.