An excursion into Short Volatility strategies.
Are there investment or trading strategies that can substantially outperform the stock market?
Yes, there are, but they always come at a price. The financial markets are generally very risk efficient – because all market participants strive to reach the highest & safest returns possible, their combined actions will largely equalize combined risk and return measures for different strategies over the long term.
Whenever a strategy shows superior performance over a recent period, return-seeking investors will flock to the strategy and eventually arbitrage the performance advantage away.
Consistent inefficiencies are fairly small, of limited duration (or at least interspersed by long periods of underperformance) and either have a strong behavioral bias or a hidden risk at their core.
Return and risk are two sides of the same coin.
Nothing exemplifies this better than a look at a short volatility ETF (e.g. SVXY) – as a generic, buy-and-hold short volatility strategy (being constantly short VIX futures which are the measure of expected volatility in the S&P 500 over the next month):
SVXY is the close cousin of the infamous XIV, which was taken off the market following its crash in February 2018 – the historical performance of the two short volatility products is virtually identical.
Why can a short volatility strategy be expected to make money?
Short volatility strategies harvest the volatility risk premium, which represents the compensation that investors earn for providing protection against unexpected market crashes. It is a source of return that is correlated with, but not the same as, the equity risk premium (the return we expect from investing in stocks). Short vol returns are characterized by extreme negative skew: periods of consistent, high returns are interspersed by infrequent, large losses caused by volatility spikes. The outperformance during good times is possible, because of this inherent risk as is clearly visible in the chart above.
Effectively a short volatility strategy insures other market participants against catastrophic risk. This doesn’t sound very desirable, but is actually the very reason for the soundness of the strategy in general (just as an insurance company has a sound business model) – high demand for insurance causes volatility sellers to be well compensated over the long run by the premia they are paid. These premia can be earned by selling options or, as in our example of SVXY, selling VIX futures to other investors, that seek insurance for their portfolio.
As a result SVXY posted the same return as the S&P over the last 8 years, despite crashing repeatedly in-between drawing down up to 93% at one time.
Today no one in their right mind would simply buy-and-hold SVXY. But it is easy to forget, that before February 2018 the crash risk was hidden (though not unknown) for many years. It is quite understandable, why short volatility strategies reached mainstream popularity in 2017, when a simple short vol ETF bested the S&P 500´s already impressive performance by almost 10x.
On the other hand, a trading strategy, that finds ways to protect against these crash risks has great potential – the blue line in the chart shows the performance of a strategy, that uses simple rules to get out of SVXY positions, when the environment is judged to be „risky“ (e.g. yellow rectangles) and consequently outperforms the S&P 500 by 220% over the last 8 years:
Short volatility strategies can be desirable, because in benevolent times they often beat the market by a mile.
How does the strategy work?
The strategy above uses two measurements to protect against crashes – it holds SVXY, unless:
- The S&P 500 falls under its long term trendline (the 275-day moving average in this example), because it is known, that volatility often stays elevated and choppy in down markets.
- The VIX Term Structure inverts (contango falls to -1,5%).
Why is the VIX Term Structure important and what does it signify?
The return of SVXY has two main components:
- SVXY rises when volatility falls.
- It rises, because it constantly rolls the (usually) cheaper current VIX future into the more expensive next month VIX future – this situation is called contango and reflects the demand for portfolio insurance. The roll yields about 4% per month on average when you are short VIX futures and is the main reason for the pronounced outperformance of SVXY over equities in „normal“ times.
Current VIX Term Structure in contango on March 26, 2019 (chart from vixcentral.com) – with expiration months and current roll yield earned by short VIX positions in yellow.
The logic behind using the VIX Term Structure inversion as a timing signal is, that the two drivers of our strategy´s return disappear, when volatility goes up and the roll yield becomes negative.
Sometimes this inversion signals a regime change in the market – marking the beginning of one of the infamous short vol crashes. The strategy exits SVXY as a precaution and waits until the return drivers are back in place. Because contango is the usual state of the Term Structure (75% to 80% of the time) and volatility tends to cluster in low volatility environments, the strategy is quite profitable over time by avoiding major drawdowns.
Additional Risks
I would never trade 100% of my portfolio in such a short volatility strategy, despite the drawdowns being more moderate since SVXY´s reduced exposure to VIX futures (0,5x from 1x) after February 2018 – all performance measures should therefore be cut in half from that point forward.
A complete loss of capital could happen however, if VIX rises by 200% or more within one day, because SVXY is short VIX futures (-0,5 x 200% = -100%). If we had a completely unanticipated event causing a market crash, such a volatility spike could indeed happen: Black Monday 1987 saw volatility shoot up by over 300%…
An easy solution would be to only invest a percentage of our capital, that we would be willing to risk in case such an extreme event should happen – position sizing is key here.
Re-insurance
I run a short volatility strategy in my own portfolio, but employ different methods to gain access to the volatility risk premium in a risk-controlled way. My strategy rules and the different instruments I use are detailed here for premium subscribers.
An effective way to manage risk in the practical implementation of a short volatility strategy can be illustrated by another concept taken from the insurance industry: Re-insurance.
An insurance company earns money insuring the risks that materialize from time to time, while in turn insuring itself against very rare, catastrophic events (analogous to Black Monday 1987 in the stock market). In practice this can be done by using option spreads or outright long options positions on volatility products (most efficiently put options on long volatility ETP, e.g. VXX or UVXY) – the re-insurance premium will reduce returns in exchange for controlling extraordinary risks.
VIX Term Structure as a market timing tool
The basic market timing signals (including the VIX Term Structure), I use throughout my portfolio, are part of my Meta Strategy. I publish a monthly newsletter, suitable for regular investors, detailing how I use this tactical strategy on a portfolio of broad market ETF – see more here.
The red arrows in this chart show the warning signals of the VIX Term Structure as they are used as one component of the Meta Strategy´s process to determine whether a portfolio should be allocated to risky or safe assets or strategies – this works, because sometimes the inversion signals a lasting market regime change in a very timely fashion:
Apart from these volatility-based signals, measurements of the price trend of the stock market and the development of economic conditions are combined into a clear allocation instruction ranging from 100% risky assets or strategies to 100% safe assets at any given time.
Currently I’m working on expanding my publications with a weekly newsletter „The Meta Strategy Derivatives Portfolio“. It will describe a highly active approach using ETF, options and futures, that will bring together an aggressive ETF portfolio with short volatility and other strategies aimed at generating risk-controlled outperformance over all market cycles. If you are interested in such a product, please email me for more details.
