An often used analogy likens volatility sellers to insurers of catastrophic risk. Is that analogy actually any good or can the case for significant differences be made and be used as an advantage?
A short volatility strategy can be implemented by selling options or through volatility products directly. Similarities to the insurance business can already be seen in the terminology used: both earn their profits collecting premiums for taking on other people´s risk. This leads to a similarly negatively skewed return profile: Many small, high probability profits are interspersed with the occasional big loss. While the strategy is likely to be profitable over the long term, just like insurance is usually a successful business (because people´s demand for insurance ensures sustainable, profitable premiums), one factor in particular may prove problematic:
The size of the premium paid varies over time, depending on the level of expected volatility (e.g. the VIX). In the insurance business the longer a negative event lies in the past, the lower premiums tend to be, because the likelihood that a catastrophe might happen fades from people´s minds and demand drops. Volatility traders become complacent and overextend themselves, which makes it hard to survive a future major volatility event – especially since volatility has the potential to spike more violently from very low levels. One can conclude correctly, that the insurance business and short volatility strategies are especially profitable after major catastrophic events as higher demand for insurance drives premiums up. I wrote about the practical dangers (and how to deal with them) of sudden volatility spikes in a low volatility environment on such a strategy in August 2017 in this post.
A hypothetical example shows how a short volatility strategy can gain an advantage over the analogous business of insuring natural disaster risk by including the protective measures of an adaptive strategy allocation – it can simply stop insuring risks at anytime without breaking a contract.
As it just took place, let´s take the case of a hurricane (analogous to a jump in volatility in financial markets) hitting the Caribbean and Florida´s coast wreaking havoc. Insurers specializing in natural catastrophe insurance in these regions may face catastrophic losses. An insurer can mainly do one thing to avoid that (apart from ensuring he is paid sufficiently high premiums), while a short volatility trader has more aces up his sleeve:
Diversification is the key. By insuring many uncorrelated risks, for example by being present in many regions or insuring a variety of independent risks, an insurance company can pay out claims while earning enough premiums on unclaimed policies to stay in business even when a major adverse event occurs. A volatility strategy can be combined with a portfolio of assets and strategies that are uncorrelated to each other. A great example is a trend-following managed futures strategy, that has an opposite return distribution and often performs strongest when short volatility strategies are facing trouble. Such negative correlation is quite impossible to find for an insurer in the physical world, but – on the other hand – correlations are much more dependable there, than in the complex, interdependent financial system.
The analogy starts to fall apart when you take into account that a volatility seller can easily close his positions at any time – nothing requires him to hold on until the contract expires. But that is exactly what we often see as taken for granted, when volatility strategies are critically analyzed as a binary buy-and-hold investment. Very seldom can you find an analysis that takes into account the possibility to close option positions before expiry or changing exposure to the strategy, but of course that is easily done in practice.
Going back to our example, we can see an additional interesting analogy: the clustering of risk. When a hurricane forms in the Caribbean, destruction in Florida becomes more probable – the pattern of hurricanes is well known and predictable to a certain degree. Now imagine for a moment that the insurer could simply cancel all his insurance contracts and return the premiums paid in Florida as soon as he starts witnessing the destruction in the Caribbean – thereby avoiding any further losses!
That would be unfair and a breach of contract (or no one would buy the policy), but that´s exactly how protection in a volatility strategy can work without any contractual limitations.
An essential phenomenon we can utilize is the clustering of volatility.
Benoit Mandelbrot observed a certain pattern in volatility variation in the sixties, which he summarized as follows: ”Large changes tend to be followed by large changes – of either sign – and small changes tend to be followed by small changes”. This has been confirmed by many academic studies since.
We can use this tendency of volatility to cluster to adapt our allocation to short volatility strategies. Whenever volatility shoots up we can reduce or stop trading the strategy, taking a small loss, until we get a sign that the coast is clear again. Thereby avoiding losses of „Florida“ proportions in our portfolio.