Straddle hedging short vol

The Backtest Notebooks

The perfect hedge is located next to the box of upticks.

Every moderately ambitious trading strategy seeks to structure positions so as to keep the gains and drop the losses. Investors want cheap insurance and free call lottery tickets. An offset that doesn’t cost you anything in the good times, but out performs the chop.

The marketing of basic options strategies targets this need directly. Covered calls give you “income” but let you stay “long” the stock. Risk premia aren’t income, and you’re a lot less long than you think. Buffer strategies sound so appealing because of their promise to protect and participate. Which they do, but not without tradeoffs.

The final boss of options hedging is managing a short volatility position. Every portfolio manager from institutional investors to retail degens want this structure. Which is ironic, because the easiest trade to make is to buy equities, which are inherently short vol. It’s not exactly an uncorrelated risk.

Yet, volatility as an “asset class” has been increasingly productized to serve this demand. OTC variance swaps gave way to listed futures, then options on VIX, and ultimately these got packaged into the sugar cereal of the investment world - volatility ETNs.

Last week we talked about imitating the structure of the SVIX product with futures as a way to get short volatility. In addition to the wild volatility, one of the pitfalls was the “-100% move” scenario.

(With perfect timing, JP Morgan has introduced a new flavor of vol ETN, where the product moves 1% for every point that the VIX does. We’ll talk more about that next week with a Product Review.)

This week in Portfolio Design, we’ll open the Backtest Notebooks to explore how a long gamma hedge via 0DTE straddles offsets a short volatility position.