How do I use 'insurance' to protect the performance of the strategy

I raise this issue because it interests me very much and I invested many hours of development to protect my trading strategies when the VIX is starting to go up fast.

I’m trying to handle the situation when volatility is declining and suddenly it changes direction. Because most of the time this phenomenon appears by surprise and without prior warning, I developed two internal strategies for the main strategy insurance:

  1. When the volatility starting a significant up trend , the main strategy buys VXX for protection and sell the same VXX position during the same trading day. This protect the account against significant intra-day movement.

  2. When volatility decreases toward the climax so powerfully like in these days, the main strategy sells part of the XIV holdings in order to not endanger to much in the near future.

The two methods are like ‘insurance’ for the main positions. They are based on probabilistic mathematics and statistics and their success rate is close to 80%.

I’d love to get more ideas how to do ‘insurance’ specifically related to the VIX products.

The strategies that I run these insurances are

I"m not sure I totally understand the methods you’ve outlined, but many people use stop loss orders as insurance, but these may have issues if something happens outside of regular trading hours. I use deeply out of the money options to insure my volatility positions against a quick but dramatic market move.


I would think the best bet is simply to scale down your risk / bet sizing when vol is low. The problem with “insurance” is the cost of carry, you better have something significant offsetting it otherwise it can really harm performance. Perhaps model some variable bet-sizing, low vol = low bet size. Yes this will further hurt already lower returns in low-vol conditions, but when it explodes you’ll be in a proper position to take advantage of the situation. We know it will return to the mean, the more it is held down, the worse the “return” overshoot can be…

I think a lot of people on C2 sort of do vairable bet sizing but unfortunately they are martingaling based on their equity curve performance, and not scaling leverage to realized volatility, and that is even worse than actually using a fixed bet size in all volatility conditions when trading vol.

On a related note, for guys/gals on here who have been trading short vol strategies, I often wonder have they really traded through some nasty black-swan event(s). Like for instance, the crash in EUR/CHF. I think everyone should take a hard look at that event and transpose the price-action on to whatever instrument(s) they are trading, and ask themselves would they survive with the kind of leverage they are employing if it happened to them tomorrow. If you are in this business long enough, it is going to happen to happen to you (and… your subscribers).

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Guys, here is a clue for you guys to figure out. If you can understand what I am saying in deep, in deep, and in deep, you then can say you really understand how the market works. This is the word: “No matter how you play with your strategy, when the time is infinity, the entire market as a unit is not beatable.” . Try to understand it mathematically.

The question is when you buy the options for protection.

If you buy them all the time so basically you pay expensive insurance premiums.
If you buy them according to particular model that tries to detect when the risk rises so interesting to know what percentage of success of this strategy.

I prefer hedging short volatility with a long position in 2 year treasury futures. The positive correlation with volatility is pretty solid, and the long term expected return is positive (as opposed to VXX).

If you believe you can’t beat the market, then what are you doing on here? If that’s the case, then everyone should just buy broad index funds and be done with it. Mathematically, if what you’re saying is true, then at the end of infinity, all market participants would have the same risk adjusted returns. I don’t think this is the case. Therefore, there will be some with better than average returns and some with lower than average returns. The philosophical questions then becomes…are the differences in returns determined by randomness, by skill, or by some combination of the two. I happen to believe that skill does factor into those differences, and that is why I’m on C2. :slight_smile:


Yep, I buy them all the time. Every time I increase my volatility positions, I buy more options. I see it like home owners insurance. I’m going to pay it every year to make sure I’m protected, and if all those premiums go to waste, then I should be thankful that nothing bad happened, not resentful that I “wasted” money. The options aren’t that expensive. Right now you can buy a Feb 24 VXX 25 Call for .19 - so that works out to about a 1% premium for 1 month of protection. Your expected return on short VXX should be quite a bit higher than that, so you can still get good returns and sleep better at night!


David, you need deep thinking…

Well something’s deep, that’s for sure! :slight_smile:


Hi David, can you please explain how buying option works as insurance , especially your trading vehicle is very volatile such as TVIX, UVXY, etc. Especially like Brexit n presidential election, if put TVIX n UVXY at wrong direction, can wipe the account very easily during night session. How can you sleep very well by using options. Thx

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Let’s say you’re short 1,000 shares of UVXY. At Friday’s close, UVXY was 23.88 and the VIX was 10.58. Let’s say that something crazy “black swan” happened this weekend, and on Monday morning, the VIX opened at 24 (about where it was a few days before the election). This would be a 127% increase. UVXY tends to have daily moves of about 80% of the VIX when the VIX has a big move. So, if that held true in this case, then UVXY would about double at the open and your $23,880 investment would now be worth nothing – and if the VIX opened even higher, then you would actually owe money. So how does one protect against this? Based on Friday’s close, you could have bought Feb 24 UVXY 36 calls for .74. 10 calls would protect your 1,000 shares, so $740 for almost a month of protection. You’re basically paying about 3% for one month’s protection that would limit your maximum loss to about 50%. I think I can make well over 3% per month shorting UVXY, so although it’s expensive, to me it’s well worth it. There are a number of other ways to play it with options that can make it cheaper than 3% by using a higher strike price or a closer expiration date.


Thanks David, now I get it. Yes, 3 percents insurance fee to protect max 50% loss is very worth it. In your model, you have fixed cost for 3 % per month, n need return higher than 3 % to offset the fixed cost before generating net positive return every month. Is this affordable to put target return more than 3 % monthly to cover the fixed cost? Thanks

Yep. Looking at my actual 2016 brokerage statement, I made $146k in ETF profits (mostly shorting UVXY), but paid $29k for the options, and paid another $4k in short interest, for a total profit of $113,000 or 186% based on the $60k I started with. Sure, I would have more than tripled my money without the options…but “almost” tripling it and knowing I’m always protected, is good enough for me. :smile:


This is the way to do it. The insurance is worth every penny in this particular scenario, because of the leverage and catastrophic loss potential of being short vol. I don’t see how anyone could compare someone shorting vol naked to this strategy unless the leverage was so low as to make a move from a 15 vix to say, 65-75 vix in one motion a survivable event. It can happen. You could also have limit up for days where things like stop losses and “I would just exit at X” won’t work.

To me, no hedging on short vol strategies is a non-starter, fully hedged - it works and it is just a matter of risk tolerance in terms of the leverage.


Hi David and thank you for your enlightening posts.

Another thing maybe worth mentioning is that your margin requirement for the short UVXY position would be lower (at least at IB) because you are hedging it. I am not sure if that would equally apply to a Regulation T Margin account as it would to a Portfolio Margin account (requiring an account over $100,000).

The success of your two systems on C2 so far seem to validate your approach.

It will be interesting to see how your strategy will perform when volatility dies down and returns from the VIX betting as well as option premiums will be lower. Do you by any chance have back tests of such low volatility periods?

I short UVXY as well, it’s not just the margin cost but the hard to borrow fee, which is currently about 10%. The good news is that (hopefully) it’s being charged on a declining balance as the value of your outstanding shorts goes down.

Do you use leverage when doing short on UVXY?

Thanks Karl, actually volatility has been pretty light recently, and the options premiums are fairly low compared to historical standards. When options get more expensive, I tend to buy shorter durations and a little higher strike prices. The nice thing about times like this when premiums are lower, I can afford to buy lower strikes, and then take some profits on small volatility strikes like we had today.

I don’t use leverage when short or long UVXY (except that UVXY is leveraged itself). My maximum UVXY exposure is about 80% of strategy value.