Volatility Strategies in Detail

Let´s put some meat on the bone and dig deeper into the practical details of the volatility strategies I use in my portfolio. These are among the most active, short term strategies I use at the moment. They also use concepts that are more off the beaten path, which makes them more valuable, but also more difficult to grasp, if you have not come across them before. They can be very lucrative, but also have a lot of potential pitfalls and non-obvious risks, as well as becoming a quite crowded strategy in 2017.
The majority of positions I take are short volatility, which has certain characteristics you have to be aware of. Research and understand the details before trading short volatility – it can be quite dangerous. I use two basic strategies, that I´ll go into in detail: systematic option selling and selling volatility directly using instruments based on Vix futures.

Basic characteristics of short volatility strategies
Being short volatility basically means that one is selling financial catastrophe insurance and lottery tickets to other investors for a premium.
Short volatility returns have a strongly negative skew: long periods of extraordinarily consistent returns (that are in practice easily scalable to very high levels) are interspersed by large losses (that will wipe you out just as easily if leverage is too high). A good indication of that is the very high Sharpe ratio for constant monthly volatility selling before the financial crisis – from 1990-2007 – of 1,3. That´s more than three times as high as the equity risk premium – commonly assumed to be the highest return deliverer. The losses during the financial crisis caused this Sharpe ratio to drop to 0,35 (1990-2009) – in line with the risk premia of other asset classes. Since 2009 Sharpe ratios for short volatility strategies have been well over 3.

In line with the previous post on backtesting new strategies, I first separate and research the basic premise that selling volatility relies on, to make sure it is solid.
Being short volatility captures the volatility (variance) risk premium (a bit of an abstract concept): the expected (implied) volatility is – on average – consistently higher than the volatility that actually materializes in the market´s movements (realized volatility). The premium is the spread between the two, which averages about 4% historically. 

Why does the volatility risk premium exist?
An explanation could be, that selling financial catastrophe insurance demands especially high risk premia, because extraordinarily large losses come at the worst times. Investor demand for catastrophe insurance (in indices) as well as lottery tickets (in individual securities) is high and they systematically overpay for them – just as people play the lottery or buy fire insurance for their homes even if it will cost them money on average.

The basic strategy in academic papers systematically sells monthly index options on the S&P 500. From 1986 to 2016 it returned 10% annually with a 10% standard deviation according to CBOE data, while buying and holding the S&P 500 Total Return Index underperformed with greater volatility: 9.9% annual return with a 15.1% standard deviation.
This passes the base rate test of delivering sufficiently long term positive returns in the strategy´s least sophisticated, undiversified form even after a devastating crisis in 2008. The CBOE has indices for different strategy variations on their website – e.g. CBOE S&P 500 PutWrite Index (PUT) or CBOE VIX Premium Strategy Index (VPD).

Volatility as a portfolio asset
Volatility can be considered a separate asset class, as it provides a unique source of return. It is correlated to its underlying markets, but it is possible to largely eliminate market directional bias by selling straddles, strangles or using hedged positions. The great advantage is that volatility selling creates a reliable income stream, even when the underlying index is moving sideways or slightly down as well as up. Income is generated, even when nothing is happening in the market, which can otherwise be a very frustrating time. In practice, this works very well for an investor withdrawing an income from his portfolio for daily expenses – it´s not necessary to rely on vastly overrated dividend– or other income strategies. Even bear markets have a light at the end of the tunnel as rising premiums in high volatility environments provide good opportunities and rebounds after drawdowns will usually be quick.

The elephant in the room are the infrequent, large losses coinciding with the worst bear markets, that will materialize sooner or later and will have to be dealt with strategically.

Systematically harvesting a constant income stream, while keeping the main focus on controlling the downside, is my goal when implementing short volatility strategies.

Volatility properties
  • Volatility always returns to its long-term mean (mean reversion effect).
  • Volatility tends to spike briefly (usually when the stock market slumps), followed by lengthier downward trends.
  • Volatility forms volatility clusters (regimes), the best predictor of future volatility is current volatility.
  • Volatility strategies manifest a tendency to rebound very quickly after drawdowns, because of rising premiums in bear markets. That implies, that the returning calm after a severe storm is the most lucrative environment for being short volatility, but also the hardest to stomach.
Implementation of volatility strategies
In practice a short volatility strategy needs great attention to detail and good risk control to keep the inevitable losses in check. I try to accomplish this by finding ways to run the strategy in favorable conditions and to scale it down or exit the strategy completely, whenever conditions deteriorate. It can provide smooth returns and portfolio leverage at no cost (selling options uses no money in your account, only collateral needs to be provided for margin).

Two approaches look very promising to me:
  • Selling out of the money put options on index ETF (insurance) and selling far out of the money call options on individual securities and ETF (lottery tickets). These carry the highest premia as investor demand for these options is highest and they systematically overpay for them. Studies show that it also works well to combine index short puts and short calls into systematic strangles, that make a portfolio largely market neutral. This type of strategy captures the volatility risk premium while avoiding to make a directional bet.
  • Trading volatility directly through VIX futures, options, ETN, ETF and their options. Volatility ETP like VXX are some of the most efficiently value-losing securities out there and money can be made taking the other side. The danger lies in the vicious spikes these securities can have to the upside.
1 Systematic option selling
My strategy doesn’t use complex option pricing models to discover mispricings (I don´t think I can realistically compete with the big boys in that area), but rather a simple trend filter and momentum rule on a diverse universe of instruments. I then sell out-of-the money put or call options to profit from harvesting the option premium, if the market follows its trend, doesn’t do anything or even pulls back a little bit – a high probability profit. It uses simple rules to scale down exposure, when a bear market establishes itself.
I decided to use a momentum rule, because momentum is one of the strongest return enhancing factors, which has to be rebalanced monthly to work optimally. This fits well with the time horizon of an option strategy. As I didn’t feel comfortable with the high turnover using momentum to invest in ETF directly, I decided it would be better, if I didn’t own the underlying ETF at all. Instead I decided to write options on the best (puts) and worst (calls) momentum candidates, thereby implementing a momentum factor long/short strategy tilted directionally by the overall trend. Factor long/short strategies can provide uncorrelated return streams, but are very hard to implement in a retail portfolio and use high levels of leverage.

The journey
I started selling put options in 2015, with very little systematic thought towards strategy, but at first learning the ropes of option terminology, where and how to trade them etc.. It has worked well, which is no wonder given the market conditions, but I am glad I kept researching and refining it before a nasty surprise happened (which is fortunately still in the future).
I´ll tell you a bit about the process of developing the strategy as it stands today – it is a lot more systematic now, albeit with a lot of elements derived by trial and error and a fair bit of discretionary leeway in instrument selection and execution – which helps to make me feel active and doesn’t do much harm.
The way I got to where I am now is very typical for a retail trader and his influences.
I first came across recommendations, aimed at individual investors, teachinghow to use options safely as opposed to leveraged gambling with lottery tickets (buying far out-of-the money call and put options). Most of these recommendations boiled down to something like this: “sell put options on safe, blue chip stocks that you are happy to buy for a discount or sell covered call options on your existing portfolio to earn extra income“, which is not the worst advice there is. I started selling put options on companies I was interested in, but in practice this proved to have some catches for me:
  • I invariably got put the stocks, that I least wanted to own. These underwater positions began to litter my portfolio and were hard to get rid of because of my aversion to realize a loss (loss aversion bias). My stock portfolio was being thrown together by chance, rather than intelligently designed. My solution was to treat my option strategy as separate from the rest of my portfolio with no intention of ever owning the underlying security. This resulted in a much clearer thought process. I cover the option before expiration or sell the position immediately, if I ever get put (which happens rarely as this is usually not in the best interest of the counterparty – they will effectively lose the remaining option premium).
  • I also have a strong contrarian streak and was soon attracted by the high premiums found in beaten down value sectors (e.g. natural resources, southern Europe and emerging markets, etc.). Unfortunately the time horizon did not work. I was not willing to stick with a position I was put long enough for mean reversion to take place and at first many of these „valuable” stocks became ever cheaper.
  • Reading more academically influenced material, I found out that the best put option premium can be found in index options, because investor´s demand is highest for protective index puts. It only looks as if individual stock options pay higher premiums at first glance. But, because they are much more volatile than indices, their profit probability is also much lower – resulting in a worse risk-adjusted premium.
  • Simultaneously I decided to quit investing in individual stocks, because it is a fight against basic probability – about 65% of stocks underperform their index. In practice it turned out to be quite impossible for me to construct a portfolio of diversified global assets as an individual investor using individual stocks and I now base the global asset allocation part of my portfolio only on ETF.
The short option strategy today
These developments and core principles led to my current strategy rules:
  • Trading universe: all global asset ETF with liquid options including equities, fixed income, real estate, commodities and currencies, plus individual securities that are doing badly as underlyings to sell lottery-type calls on. Finding suitable ETF is still done by manually looking for option availability and tolerable bid-ask spreads.
  • Basic entry rules: to sell puts (for short calls use reverse criteria) do a monthly check: if ETF price is above its long term moving average (150 to 300 days, I use a 275 day SMA to be a bit on the longer side from the commonly used 200 day SMA) and 12 month momentum has risen to the top 20% in the last 1-3 months (this screener works well), write puts on all ETF passing the screen, checking for diversification, liquidity and capacity of portfolio allocation.
  • Adaptive portfolio allocation: Calculating with the effective exposure to the underlying, I allocate between 50% and 150% of capital (NAV) to short options (this includes direct volatility trading described below), which will lead to a maximum leverage of the entire portfolio of 2,5 times – with hedging in place to neutralize some market direction. I´m scaling down exposure in bear markets and high volatility regimes and cap the amount of option writing at my current maximum allocation. The more positive trend and momentum candidates pass the screens, the higher my overall allocation and vice versa.
  • Position size, strikes and time to expiration: Each position is calculated by writing option premium for 0,5% of capital, which automatically results in scaling positions approximately by the underlying´s volatility (the underlying´s volatility determines option prices). Strikes are 2% – 5% OTM for puts and around 5% OTM for calls. Expiration dates are spread equally from 2 to 4 months to diversify across time, new positions are placed in the slots, that are opening by exiting existing positions.
  • Diversification and market neutrality: ETF are selected by liquidity and diversification across sectors, countries and asset classes, avoiding concentration in any particular area. When allocation capacity is full, no additional options are written until the next month. The market´s direction is hedged by writing calls on downtrending securities, depending on the current trend (conceptually this results in a strangle spanning different, correlated securities): the more ETF show a positive trend, the more the option portfolio will be positively tilted. When more markets trend downwards short call exposure is scaled up and overall leverage scaled down.
  • Exit rules: option positions are exited at a 50%+ profit or via stop loss at -100% or at the break of the long term moving average of the underlying.
  • Strategy statistics: I have made a lot of changes, but since late 2015 the win rate was 85% with an average loss at -39% and an average win at 17,5%. Typical for a negative skew strategy is the large amount of small wins with few, larger losses, but because of the benign market environment and absence of major adverse events these statistics are not representative of a full cycle.
In general harvesting the volatility risk premium is a very robust strategy and can be implemented in many different ways successfully as long as its strongly negatively skewed return distribution is taken into account. The premium is likely going to be quite stable on average (while undergoing cyclical changes), as it relies on investor´s robust desire to insure themselves against losses, the cost of which they are willingly paying.

For a period of several months I tried to use Vix futures options (long calls and short puts) as a hedge to be able to lever up this short option portfolio more. But I quickly realized just how incredibly expensive this hedge turned out to be, did more research into the subject and switched it 180 degrees to trade volatility directly, primarily on the short side.

2 Direct volatility trading
Volatility trading revolves around the VIX (which is not directly tradable) and uses relatively new trading instruments, making it executable for individual investors. Here is a timeline of the most important instruments you can use and the limits to testing historical performance (the instruments I use in my portfolio at the moment are in bold):
  • VIX futures contracts began trading in 2004
  • VIX options began trading in 2006
  • VIX Short-Term Futures ETN VXX was launched in 2009, its inverse counterpart XIV in 2010, the 2x levered version UVXY and the inverse ETF counterpart SVXY in 2011 as well as many other products.
  • Options on VXX were introduced 2010, on UVXY and SVXY in 2012
So what´s the difference? Why would I trade volatility directly, if its based on the same basic volatility premium as short options strategies?
  • The Vix Futures Term Structure adds an additional source of return, it provides a considerable roll yield that is positive for a short position about 80% of the time and a part of which can be harvested.
  • We can derive different trading signals with important market information contained in the term structure.
  • Historical performance shows different return distributions for VIX derivatives and S&P 500 options – it will add diversification.
  • The basic risk characteristics are the same however, therefore I trade volatility directly, but put it in the same portfolio allocation bucket as short option strategies.
Vix Futures Term Structure
Roll yield is caused by market participants predicting the VIX to mean revert, which is reflected in different prices for futures with different expiration dates. On average the prediction is overdone and the futures settle closer to the current VIX price – the roll yield can be partly harvested as an additional volatility risk premium.
When short the roll yield is positive when the Vix term structure is in contango and negative when in backwardation, which you can look at in detail at this great website: www.vixcentral.com.





Basic viability of volatility strategies
The Vix Futures Term Structure is in contango with a positive roll yield more than 80% of the time – to earn the realized yield we need to be short Vix futures (short volatility). This is where volatility strategies make their money, going long volatility only in severe bear market conditions, if at all.
A proxy for the performance of an unfiltered strategy of being continuously short Vix and earning the roll yield, is the inverse Vix ETN XIV (or near identical ETF SVXY which I use because it has options). There is data that models virtual prices of XIV back to 2004, which gives a good idea of the volatility and returns of being short Vix across a full cycle including the financial crisis 2008:


Buy and hold XIV would have yielded compound annual returns of 31,80% (an enormous absolute return of 4340% over 13 years and a quarter) with an extremely high standard deviation of 59% and a Sharpe ratio of 0,54. To put this into perspective: XIV had better risk-adjusted returns than equities over the same period, but the high volatility would have resulted in huge drawdowns of over -92% at times. A very simple solution to make that tolerable, would be to scale down exposure by a factor of about 5 to reach a performance similar, but a bit better than equities. That is very useful in itself, as scaled down buy and hold XIV exposure could be used to diversify and add simple, low-cost leverage to a portfolio without using margin or derivatives.

Edit February 2018: An unprecedented volatility spike (VIX up 115.6% on February 5th) has triggered a discontinuation of XIV after falling more than 90% a day after the Term Structure signaled to exit all direct short volatility positions. This stresses the inherent danger and the importance of diligent risk control through moderate position sizes and strict stop losses.

XIV suffers from volatility drag, much like a leveraged ETF, which prevents it from harvesting the entire realized roll yield. On average, this drag is costing us returns at a rate of about -10% to -20% per annum.

The 2x leveraged long volatility ETN UVXY suffers from a multiplied volatility drag contributing to its extremely negative performance, otherwise caused by constantly paying the roll yield.
UVXY is one of the most efficient money incinerators I have ever seen – look at the logarithmic 2004 – 2017 chart! I just wonder, who would ever buy such a thing?


The reason is the enticing upside (almost vanishing in the chart), when all other things go to hell, as they did in 2008. Had UVXY existed then it would have skyrocketed from 250000000 to 3680000000 between September and November 2008, a gain of 1500%! Today it has fallen all the way below 9 with several inverse stock splits along the way.
More interesting, of course, is profiting from the downtrend and here the rub lies in the upward spikes, that can wipe out a long accumulation of profits.
Several sources with detailed, backtested strategies (here is a good compilation), as well as my own tests and practical implementation, suggest that a systematic, active approach could cut XIV´s volatility roughly in half, yielding a Sharpe ratio of around 1,2.
The basic idea is to run the strategy when roll yield and the volatility risk premium is positive and stop trading when it turns negative and volatility spikes. Different signals and instruments can be used and the good thing is, that all of them should work similarly with a positive result over time as long as you take care not to overextend yourself.

Trading signals
I put together an overview of the most interesting possibilities (my own choices for strategy implementation in bold):
Strategy rules
I have looked at a variety of instruments and time frames to implement these signals into a coherent strategy and have found considerable differences in performance characteristics and risk exposure. As this is the most active part of my portfolio aimed at strong growth, I decided to diversify the strategy across four different instruments and several different time frames. I found, that in practice I could generate an income stream through short-term implementation, while smoothing performance with less volatile medium-term elements. Each sub-strategy also works on its own.

  • SVXY (XIV) and VXX medium-term trend following. The majority of strategies I found, trade both or one of these ETP. The aim is to reduce the drawdowns and volatility while participating in most of the upside of short volatility ETF SVXY (or near identical XIV). The main reason I use moving average cross over signals here is, that these generate slightly different entry times from the other sub-strategy signals.
    • Entry SVXY on moving average cross 9 day SVXY SMA above 60 day SVXY SMA and contango > 0 and S&P 500 > 275 day SMA; exit SVXY on moving average cross 9 day SVXY SMA below 60 day SVXY SMA or contango < -1,5%; position size 10%-15% NAV.
    • Long volatility VXX (to hedge tail risk): entry if contango < -3% and S&P 500 < 275 day SMA; position size 10%-15% NAV.
  • Long UVXY put option. The advantage of being long puts is the built in maximum downside protection (in contrast to extremely risky short calls), while participating in the upside with leverage (about 4 times SVXY with the strategy parameters below). As the tendency of UVXY to lose value quickly is well known, the puts unfortunately demand a very steep premium. UVXY has to fall considerably for the put to become profitable, but nonetheless I consider this the best risk-reward strategy when looking at my backtests. Long puts have the highest exposure in the direct volatility trading part of my portfolio.
    • Long UVXY put rules: buy UVXY put when Vix term structure returns to contango > 0 after being in backwardation, expiration in about 5 months, strike OTM at last UVXY low; exit after two months (if UVXY should be at a relative high then, exit after three months); position size 5%-10% capital (put premium).
  • Weekly UVXY short calls. UVXY calls command very high premiums mirroring their crazily high volatility (about 10%-15% premium for an ATM call 3 weeks to expiration at the moment) and they have the very strong directional UVXY bias working against them – resulting in a high probability trade when we are short. These calls lose more than 50% of their value (our profit) over the course of a week or two most of the time, but can spike up a multiple of that within a day or two every once in awhile. The aim is to create a high weekly income stream and avoid lethal spikes without getting whipsawed too much. A possibility is using call spreads for protection, but I found the trading costs getting very high in practice and decided to use a stop loss rule on a naked call instead. This leaves the strategy exposed to extreme black swan events and overnight gaps, a risk I mitigate through relatively small position sizes.
    • Selling UVXY calls weekly rules: the idea is to sell a call each friday to earn the premium, when conditions are favorable. I start the strategy, when the Vix term structure returns to contango > 0 after being in backwardation; sell one third position size call, three weeks to expiration, strike 2%-5% OTM, repeat each friday – the strategy will accumulate three open positions with staggered expiration dates; exit at expiration or at emergency stop loss at -200% or exit and stop trading the strategy when contango < -1,5%;  position size for 3 call positions 0,75%-1,5% NAV (call premium).
    • At the stop point (contango < -1,5%) a considerable amount of the earned premium will be given back – the rules aim to keep about 50% of the premium on average over time. If results deviate from this goal too much, I will change or discontinue the strategy. I posted a case study and update with several adjustments in the strategy´s rule following a strong double volatility spike in August 2017.
  • Overall position size and exposure. In combination these strategies use a maximum of 15% to 25% of capital, but often only a part of the strategies is in the market simultaneously. Because of the inherent leverage in the options (the puts used are about 4 times, the calls about 12 times levered compared to SVXY), this will translate to a maximum exposure of approximately 50% to 100% NAV. I cap my maximum exposure at 75% NAV and only use full short call position sizes, when put and SVXY positions are so far in the green, that I can set a break even stop loss and remove them from the equation or if they are already closed.
    The position sizes on the high end are the maximum growth exposure (using the Kelly criterion) – I use a mid-level exposure at the moment. With a growing account size or growing skepticism about the market, I plan to move towards the position sizes at the low end or scale down even further.
  • Strategy statistics: I closely observe real time trading data, but so far the strategies have only been active for a couple of months – with very good results. Backtesting the combination of strategies from the inception of UVXY (which excludes the very negative 2007-2009 period) yielded 39% annual return with 32% volatility, a Sharpe ratio of 1,2 and a maximum drawdown of -23% – in line with outside sources, but I expect future drawdowns to double easily given the volatility.
Combined, these strategies amount to a rather high exposure to short volatility strategies in my portfolio and I monitor them closely for any signs of weakness and over-leverage. This high octane component is aligned with my personal incentives: I prefer capital appreciation over preservation at this point in time and I see these strategies as the best growth driver in my portfolio in the current market environment. A goal of high growth necessitates concentrated bets in the right environment – while being aware of the accompanying risk.

Risks to the short volatility strategy in the future
Always be aware of the negative skew characteristics of the strategy, which is the reason for its high premiums. It provides insurance against catastrophic risks after all. Benign market conditions can easily lull the investor to carelessly employ overly high levels of leverage, which will be deadly in a negative event.
The strategy is also becoming more and more crowded. The size of the volatility risk premium may decrease as more investors seek to harvest it. Short volatility is becoming a very popular strategy and, as almost everything else, it is cyclical in nature and will have severe drawdowns when everyone should choose to run for the exit at the same time.

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