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Backtest Notebooks

For all the talk of short volatility, sometimes it would be nice to be long some volatility. Like today.

When the market dumps, we expect long volatility to hedge this position. There is a fairly strong correlation between the direction of underlying prices and the price of volatility.

As equity prices are falling, uncertainty and turbulence intuitively follows. Yet the relationship between these two is not always lock step, and if you want to use volatility products, or options to hedge your position, there is a delicate balance of timing and rebalancing.

In our short volatility discussions, a recurring theme has been the ratio of moves in one product to another. Stylistically, VX futures move up 66% (15 to 25) as the market corrects down 7%. If you want these to hedge, your portfolio needs to have the appropriate weights- roughly 90/10 weighting biased to stocks.

However it’s not quite that simple either. If you simply bought VX futures with 10% of your portfolio, most of the time you’re going to lose 10-15% on that as contango and VRP decay. The other 90% now has a hurdle of 1-1.5% returns just to compensate.

Just as there are short products like SVIX and VYLD, the opposite long vol products exist in ETNs like VXX or UVIX. While volatility makes much larger moves than equities, the payoffs on these delta one products are fairly linear. (Even with a 2x like UVIX).

Options on volatility have convexity potential, where 66% underlying moves can be a 10x in price space. This makes a potentially more attractive long volatility hedge, because the insurance premiums that expire in calm times are not as much of a drag.

We’re not the first traders to think of this. Plenty of buyers both institutional and retail love VIX calls. There is in fact one notorious trader who will selectively purchase calls worth approximately $0.50 when he/she suspects a volatility event. The nickname that garners is obvious.

Today in the Backtest Notebooks, we’ll explore what the experience of using VIX calls looks like as a hedge in volatility events using both an “always on” test, as well as with a signal based on the VIX term structure.