Thin premium or broken strategy: how to tell

Two different problems

A short premium strategy earns the variance risk premium: implied volatility at entry minus the volatility that actually happens. In our book that premium ran +8 to +12 volatility points in the summer and fell to zero in October. Returns fell with it. That is a regime: the market paid less, and any strategy selling the same premium earned less.

Decay is different. It means the premium held up but the strategy captured less of it, because the edge was crowded out, the rule overfit, or execution got worse. Regime is a reason to wait. Decay is a reason to change something. They look identical on a profit chart.

How the test works

Each resolved trade carries its own premium (implied at entry minus realized over the hold). Trades are grouped by the week they resolve. The earlier weeks define a line: weekly return against weekly premium. Then we ask whether the recent weeks sit on that line. If return fell and premium fell by two points or more, and the line explains the drop, it is regime. If return fell and premium did not, it is a warning. Decay is called only when the recent weeks sit well below the line (a z-score of -1.645 or worse) and the recent average return is below zero.

Those thresholds were written down before the first read and are not tuned afterward. At least eight weeks of results are needed before any call.

The first reads, and an artifact we fixed

The first strategy with enough weeks read regime: weekly return fell from 2.10% to 0.97% on collateral while premium fell from 5.9 to 2.9 volatility points. Returns still positive, premium thinner. Not decay.

A few days later the test called decay on two strategies, and it was wrong. Realized volatility had run above implied, so the premium went from about +7 to about -7 points, far outside the calm range the line had been fitted on. The z-scores came out at -5.8 and -33 because the line was being extrapolated thirteen points beyond its data. The fix: a premium more than one point outside the fitted range is never called decay.

What it changes in practice

When your short premium results drop, first check what the premium did over the same weeks. If implied minus realized collapsed, your strategy may be fine and the market simply paid less, which is not a reason to change rules, sizes or underlyings. Our lesson on IV versus realized volatility explains why you cannot dodge those months at entry. And be wary of any model, including ours, that extrapolates from calm data into a market it has not seen.