Volatility Strategies in Detail - systematic individual investor
The losses during the financial crisis caused this Sharpe ratio to drop to 0,35 — in line with the risk premia of other asset classes. Since Sharpe ratios for short volatility strategies have been well over 3. In line with the previous post on backtesting new strategies , I first separate and research the basic premise that selling volatility relies on, to make sure it is solid. Why does the volatility risk premium exist? An explanation could be, that investors selling financial catastrophe insurance demand especially high risk premia, because extraordinarily large losses come at the worst times.
Investor demand for catastrophe insurance in indices as well as lottery tickets in individual securities is high and they systematically overpay for them — just as people play the lottery or buy fire insurance for their homes even if it will cost them money on average.
Volatility Strategies
Basic probabilities to earn above average returns over time are strongly in our favor. The CBOE has indices for different strategy variations on their website — e.
- Market Volatility: Friend or foe? | Special Report | IPE.
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Volatility can be considered a separate asset class, as it provides a unique source of return. It is correlated to its underlying markets, but it is possible to largely eliminate market directional bias by selling straddles, strangles or using hedged positions. The great advantage is that volatility selling creates a reliable income stream, even when the underlying index is moving sideways or slightly down as well as up.
Income is generated, even when nothing is happening in the market, which can otherwise be a very frustrating time. Even bear markets have a light at the end of the tunnel as rising premiums in high volatility environments provide good opportunities and rebounds after drawdowns will usually be quick. The elephant in the room are the infrequent, large losses coinciding with the worst bear markets, that will materialize sooner or later and will have to be dealt with strategically. Systematically harvesting a constant income stream, while keeping the main focus on controlling the downside, is my goal when implementing short volatility strategies.
In practice a short volatility strategy needs great attention to detail and good risk control to keep the inevitable losses in check. I try to accomplish this by finding ways to run the strategy in favorable conditions and to scale it down or exit the strategy completely, whenever conditions deteriorate. It can provide smooth returns and portfolio leverage at no cost selling options uses no money in your account, only collateral needs to be provided for margin. It uses simple rules to scale down exposure, when a bear market establishes itself.
I decided to use a momentum rule, because momentum is one of the strongest return enhancing factors, which has to be rebalanced monthly to work well. This fits well with the time horizon of an option strategy.
In general harvesting the volatility risk premium is a robust strategy and can be implemented in different ways successfully as long as its strongly negatively skewed return distribution is taken into account. For a period of several months I tried to use Vix futures options long calls and short puts as a hedge to be able to lever up this short option portfolio more. But I quickly realized just how incredibly expensive this hedge turned out to be, did more research into the subject and switched it degrees to trade volatility directly, primarily on the short side.
Market Volatility: Friend or foe?
Volatility trading revolves around the VIX which is not directly tradable and uses relatively new trading instruments, making it executable for individual investors. Here is a timeline of the most important instruments you can use and the limits to testing historical performance the instruments I use in my portfolio at the moment — May — are in bold :. Why would I trade volatility directly, if its based on the same basic volatility premium as short options strategies? Roll yield is caused by market participants predicting the VIX to mean revert, which is reflected in different prices for futures with different expiration dates.
Notify me of new posts via email. But in recent years a number of volatility-related exchange traded Funds ETFs and Exchange Traded Notes ETNs have been launched which make volatility trading accessible to the retail investor and fund managers without the need to access futures markets.
Our objective is to devise a trading strategy using them. We document where volatility returns come from, clearing up some misconception in the process. Then we illustrate five different strategies that will appeal to different investors.
Volatility Trading Strategies
Four of the strategies are simple to describe and implement. We illustrate how these strategies can be incorporated into existing portfolios to reduce portfolio risk especially in times of crisis. However, there are also technical tools that can identify potential upcoming volatility in almost any market. Volatility — Technical Indicators — Indicators and Signals Volatility-based indicators are valuable technical analysis tools that look at changes in market prices over a specified period of time.
The faster prices change, the higher the volatility. The slower prices change, the lower the volatility. It can be measured and calculated based on historical prices and can be used for trend identification.