VIX systems got crushed

Trading and Markets
41

Not necessarily if the move is big enough. Assume you are long XIV, except for being long 1 Dec VIX 20 call for every $3,000 of your account. So for a $30,000 account, you buy 10 Dec VIX 20 calls for about $120 each (a $1200 purchase to partially insure $30,000).

If over an extremely bad week (or month) the VIX jumped 7 fold to its 2008 high of 80, your 10 VIX 20 calls alone would probably be worth about $45,000-$65,000, nearly doubling the value of your account, even if your XIV position became worthless. So for really huge moves, VIX calls can fully protect the account.

If the VIX jumped to 53 (its 2015 high), then the VIX calls alone would probably be worth about $28,000-$38,000.

If the VIX merely tripled (the hypothetical) over the next month, the Dec options would probably be worth about $14,000-$17,000, so this would somewhat offset a huge drop in the value of XIV. You are correct that you would still lose a big chunk of your account.

42

And what about if you insure account better by buying 20 Dec VIX 20 calls for about $120 each (a $2400 purchase to insure $30,000)? Sure, you not targeting 100% return on strategy annually, just maybe low 2 digit number, but is it trading volatility about risk control?

43

Well, given that you would have to buy this protection about 2.5 times a year, that would reduce returns by about $6,000 a year. Maybe that would be worth it, maybe not. But buying 20 such calls would probably about fully protect you from a tripling in VIX since they would be worth about $28,000-$34,000, and a tripling in VIX was the original hypothetical.

So, yes, a tripling in VIX from current levels could approximately be fully insured against by buying 20 VIX 20 calls.

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44

I was thinking about constant variable protection with options, not just 2.5 times a year (predicting volatility is not simple task and if you can, why not reduce position). Cheaper way is mixing buying calls on volatility and selling puts on gold/bonds (collecting premium). Also hedging with gold/bonds is an option long term. And the cheapest way is to reduce position. Risk model can be complicated, but doesn’t need to be expensive as many think.

45

You said: options protection is a much more “complete” form of protection.
I went to your strategy to see how your strategy was protected by options, but it seems you got hit just as every other VIX strategy.

46

Robert, wit all respect, I will compare stop as hard landing and options/reduce position as parachute

47

I’m not David, but::

  1. he was not hit just as every other VIX strategy.(Volatility Return for example)
  2. if move in VIX was twice bigger, benefit of options is more visible
  3. VixTrader did again good job based on timing and position size (so far there are no > 1% gaps)
48

David is doing it right, the thing is those options will go completely insane when the “event” happens, it won’t be a linear payout, it will exponential, he is being very conservative by estimating a linear payout beginning at option strike price…

As a recent example I had a far out of the money long put hedge that went up 30 x (30 times) from what I paid during the Aug 24 2015 mini-crash.

Buying OTM options is going to be a losing proposition in and of itself, they are insurance, but when short volatility with any kind of leverage (be it via ETFs/ETNs, futures, short naked premium options strategies, etc), it should be required insurance!

People who think they are generating alpha from being short vol with no tail hedge will one day learn that in fact they are just selling disaster insurance. If the returns are no good when you properly re-insure, then you don’t have a real advantage and time for a new approach or to leave the space…

What will get the people who aren’t tail hedging will be a lock limit down S&P overnight and then it opens lock-limit down and it’s goodbye, turn the lights off on your way out. I bet there were people naked short vol soiling themselves on the night of the U.S. election when futures were lock limit down overnight, if it hadn’t turned around dramatically in the Asian and European session… well… there would be less vol strategies on c2 that’s for sure :grin:

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49

There are many contexts that can be discussed here.

I was referring to the point of overnight protection. And historically I didn’t see that VIX have ever jumped overnight more than 40%. You’re welcome to prove me wrong. This was the main reasoning here regarding the inferiority of a stop loss vs. options hedging. There is not such inferiority when you speak about a move that takes weeks or months. Agreed?

Regarding your example, of holding relatively near calls in parallel to the main position, this isn’t merely a hedge of a short volatility position, you have quite a significant, and dominant, long volatility component, hence the benefit from volatility spikes. And, with $1,200 for 3 months, or $4,800 per year, you are looking at 16% yearly cost.

A sidenote: I’m not crazy about comparisons to physical assets insurance, but since this was brought up, my house is valued about $280,000, and I pay an insurance premium of $160. A year. That’s it. Figure out what kind of protection you get in options if you pay 0.05% of the position value. Want to look at cars? I pay about 4.5% of my car’s value for a full insurance premium that covers practically everything, with no deductions. So if we want to compare, let’s compare… Bottom line: options insurance is VERY expensive.

Now, perhaps 16% seems a small number when you look at some of the systems here, but what does a year or two with record low volatility say about the long term? I am trading a strategy that is tested since 2009, and my belief is that over years, under many different kinds of markets, a reasonable return to expect from short volatility systems, when your timing is very good, is closer to 30% a year, if drawdowns are kept to around 20%. Take 16% away from that and you’re left with a system that is probably not worth trading. I’d say at least consider other alternatives.

And finally - recall I said tested from 2009? The fall in 2008 isn’t there. What does it mean? that you can expect the observed 20% DD I mentioned to be significantly larger if 2008 happens again in the period you’re trading. This means you shouldn’t trade it with any significant portion of your account. Anyone who thinks that options can magically provide an insurance for a 100% return a year, well, good luck.

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50

Reading again the title of this thread: “VIX systems got crushed”.

Do you know what was the maximum overnight upmove of VIX this month? 5%.

51

Hey, VXX just went up 300% today.

Ahhh, it’s a reverse split, 1:4 :slight_smile:

https://sixfigureinvesting.com/2013/08/next-vxx-reverse-split/

52

Wow, quite a lot of activity on this post overnight! Crazy what can happen overnight! :slight_smile:

So, a few comments –

  • At what price to buy the options and how far out? There’s no right answer to this question, it really depends on one’s risk tolerance. Historically, I’ve bought them 15-40% out of the money. I tend to ladder the options with different strike prices and buy them 2-3 weeks out so that they don’t become “outdated”. When the VIX is low (and one may argue more dangerous), options are cheaper so I buy them closer to the underlying price; when the VIX is high, options are more expensive, so I buy them further out…this tends to work out pretty well, because when the VIX is high, I usually have a lower short vol exposure, so I don’t need as many options.

  • How much does this actually cost? According to my 2016 IB annual report, for my IRA account: Starting Value: 65k, ETP gains: 42.5k, Options losses: 2.5k, Ending Value: 105k. So the options cost about 6% of the gains, or about 3% per year based on the average account size. Now, in my leveraged account, the cost of the options protection was quite a bit more: Starting Value: 60k, ETP gains: 146k, Options losses: 29k, Interest: 4k, Ending Value: 173k. The options cost 20% of the gains and 25% per year based on the average account size. The reason they are so much higher is that when one is using leverage, one has to buy quite a bit more options protection to keep the maximum loss around desired levels.

  • There may not have been a VIX spike of over 40% overnight historically, but just because it hasn’t happened before, doesn’t mean it can’t happen now. My house was built in 1985, and in its entire 32 year history, it’s never caught fire – one buys insurance for what can happen in the future not for what has happened in the past.

  • Regarding the comment about my strategies, they did very much as expected over the last few weeks. Going in, I had a high short vol allocation and had options with strikes set to kick in with spikes of 15-40%. With the spikes that we got, a few of those options paid off (some of which I sold as I reduced my ETP positions), most of them were within 5% of being in the money, and a few were a little further out. So the 20% drop for my margin strategy is within the planned allowance, but no matter how much worse it would have gotten, even without reducing my positions, my maximum loss would have been around 25%. Some strategies had much lower drawdowns this month, and some had gains. I commend them on how they managed! Last week I sent messages to the developers of VIXTrader and SMTiming to congratulate them on how well they did. Will that be the case next time or the time after? We’ll see. So when I said “more complete form of protection”, that shouldn’t imply that there won’t be large losses, but what it does imply is that it offers the most complete protection against catastrophic losses.

  • Nothing “magical” about options – it’s all math. You pay for protection. If you want a lot of protection or want to protect against a leveraged account, you pay a lot! If you want moderate protection, you can buy it for a decent price.

  • If you use Interactive Brokers, in Account Management, under Risk Reports, there’s a “Stress Test”. That will approximate what IB sees as your maximum loss. If you’re following volatility strategies, you should check it out. If you’re ok with what you see, great! If not, try to figure out what strategies are contributing to the “not ok” part.

Ok, time to get back to work! :blush:

Take care,
David.

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53

Return of your strategy over the last 6 months is zero. Is this expected too? :slight_smile:

54

I tend to agree. However, what hurts many strategies is a sequence of small losses (such as those you incurred this month, over a very moderate increase in volatility, and you may want to double check with your insurance agent the small print there, coz it didn’t help much) rather then catastrophic ones.

In any case, I do hope your next 6 months will be better the last 6 months, and yes, it IS time to go back to work :slight_smile:

55

Technically, I’ve had a 6.75% gain over the last six months (now go back a bit further and it’s around zero) - but point taken - the last six months has been disappointing. Luckily I’m in it for the long term, not just for any six month stretch. :slight_smile:

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56
  1. Interesting discussion BUT you miss the most important point: Stop Loss. If you do not have one, your risk management is not really a good risk management, even if you buy options to insure yourself for something that never happened yet but forget to take care about something that happening every few months!!
  2. Thanks for your warm words! I expect to do better in the coming crushes… :thumbsup:
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57

Shorting vol is like handling a wild animal. Just when you think you have it tamed, and it’s never actually tried to rip your throat out, it goes aggro and attacks you. As David said, just because something hasn’t been observed within a relatively short look-back of a data set with regard to an massive overnight VIX spike doesn’t mean it won’t, this is the definition of black swan risk.

Some vol sellers here “dodged” this latest blip, but the thing is that regardless of whether that was luck or skilled timing, one day they will have short vol on and there will be an exogenous shock and all the timing and the luck in the world won’t save you if you don’t already have control of the risk up front. Think something like the Fukushima disaster… there is no “timing” something like that…

So the question is will you be open for business the next day if VIX spikes from say 15 to 40 overnight or even during the day in which it is lock-limit and there is no ability to actually execute a stop order in any related product? To deal with this you either have to size down or buy insurance, or both. I like the both option if there is any leverage on at all…

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58

Yes good points. The options protect against catastrophic moves (over 30 %). But a good stop loss strategy is very useful for protection against the regular big moves (over 7-10 %).

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59

Quite a valuable discussion going on here, nice. :slight_smile:
Many points regarding the type of protection were already mentioned so I just want to throw in another aspect. Behavior of big financial institutions.
They don´t simply unload all their stocks over night or try to hedge it all at once with ES/VIX futures. Why? Because they would destroy their own market. Big financial institutions need buyers to unload. So even if we see a dramatic overnight movement, it is very likely to be partially bought back so the market regains some kind of stability. Only then those big traders can continue to sell their equities - which results in a strong down trend for sure. But it´s not just a boom - done - movement.

So my point is that albeit the true possibility of black swan events the market will not go completely berserk for the reason statet above. I very much recommend the book “Reminiscences of a Stock Operator” by Edwin Lefévre, so much of it is still true in today´s markets. And it´s a fun read. :wink:

Anyways, that´s why I developed my strategy around the more frequent drawdown events by using stop loss and meanwhile managing my risk in a way that a true blackswan can not annihilate my account (position size). It would be hit hard though, that´s inevitable. (a complete dodge would be possible with my system but based on luck so I don´t count on that)

On a sidenote, I like how many different and sound approaches of trading volatility are gathered here. The more investors educate themselfes about those different ways the less developers would feel like competing with one another. For example I actually don´t compete with David´s strategies as we have completely different approaches and goals. So I do wish all the best and a grain of luck to him and other volatility traders.
For investors variety is key. And variety we have. :slight_smile:

Peace and love,
Alex

60

Essentially you are right - tail risk is there, and if you don’t hedge for extreme events your size better be small. However, what bothers me, is that one can observe that shouting: “options hedge! options hedge!” is too often used as an excuse by some not to take losses when those need to be taken. Then, the (stupid, I must say) comparisons to physical assets insurance might give subs the illusion their money is somehow insured against events that WILL happen. Wordings such as “complete protection” further encourages such misconceptions.

Someone commented here - what would have happened if this month’s jump was 3 times larger? well, valid question, but I’d also ask, “what would have happened if this month’s jump happened 4 times a year instead of once?”. I hope it is clear that such a minor increase in volatility isn’t at all extraordinary and is very likely to happen again.

Worried about VIX tripled overnight? good. Start by handling 5% increase, without incurring 20% drawdown, I say.

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