Intro to Trading Volatility

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Melvin Cole
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1 Intro to Trading Volatility Before reading, please see our Terms of Use, Privacy Policy, and Disclaimer. Overview Volatility has many characteristics that make it a unique asset class, and that have recently caused VIX strategies and products (such as XIV and VXX) to grow in popularity. It is crucial, however, to have a full understanding of what volatility is and how volatility products behave. This guide is meant to give you a solid foundation for understanding volatility. What is Volatility? In most cases, volatility is synonymous with standard deviation. The tricky part is that there are two types of standard deviations that you will come across: historical standard deviation (realized volatility) and expected standard deviation (implied volatility). Realized Volatility Realized volatility is simply the standard deviation of historical returns. This could be daily returns for the last 10 days, monthly returns for the last year, yearly returns for the last 10 years, etc. Often times, to make an apples to apples comparison, realized volatility will be stated in annualized terms, regardless of the time period. The thing to note here is that volatility is not linear across time you cannot simply multiply monthly volatility by 12 to get annualized volatility, for example. Rather, volatility is related to the square root of time if we wanted to annualize monthly volatility, for example, we would multiple the monthly standard deviation by 12. Example: 5% monthly volatility = 17.32% annualized volatility (5% * 12) Annualizing Volatility Daily Volatility * 252 = annualized volatility Weekly Volatility * 52 = annualized volatility Monthly Volatility * 12 = annualized volatility

2 Let s back up a minute and think about what an annualized volatility of, say, 17% really means. To keep things simple, we like to follow the so-called rule. If a stock has an annualized volatility of 17%, the rule tells us that there is a 68% chance the stock will trade ±17% (1 standard deviation) of its current price over the next year, a 95% chance it will trade ±34% (2 standard deviation) of its current price over the next year, and a 99% chance it will trade ±51% (3 standard deviation) of its current price over the next year. Keep this in mind as we proceed. Implied Volatility Implied volatility is the markets expectation for volatility over some period of time (again, usually stated in annualized terms), and is observed from option prices. More specifically, implied volatility is a plug in the Black-Scholes option pricing formula (it is the only unknown variable) that tells you how large of an expected price move of the underlying (in our case the S&P 500) the market is pricing into the cost of the option. The higher the implied volatility, the bigger the expected move, and the more expensive the option. Understanding implied volatility is important for understanding the VIX. What is the VIX? The VIX is as widely discussed, but not widely understood. So, what is the VIX? The VIX is simply the implied 30-day volatility of S&P 500 options. To calculate 30-day implied volatility of S&P 500 options, a weighted average of implied volatility across a range of puts and calls is taken such that the resulting weighted average represents synthetic 30-day implied volatility (the exact calculation is quite complex, but not necessary to know for successful volatility trading). So, what does it mean when the VIX (often referred to as spot VIX) is 17, for example? First, note that this really means 17%, not 17. Second, this (literally) means that 30-day implied volatility of S&P 500 options is 17%. Finally, going back to our rule, it means that the market is pricing in a 68% chance of a 30-day annualized move in the underlying of 17%. Admittedly, this can sometime be confusing, so it is often helpful to convert the VIX to a monthly basis. To do this, simple divide the VIX by 12. So, in this example, the market is pricing in a 68% chance of a ±4.91% move over the next month, a 95% chance of a ±9.81% move over the next month, and a 99% chance of a ±14.72% move over the next month. Note: the VIX is often referred to as the fear index when markets fall, the VIX tends to increase. This is because when fear increases, market participants often purchase S&P 500 put options to hedge their portfolios. This increased demand for options increases the implied volatility of the options (increases the price), driving an increase in the VIX. Now that we understand what the VIX is and how it s calculated, let s discuss its characteristics.

3 Characteristics of the VIX To understand volatility, it s important to understand its characteristics. Mean Reversion The VIX has been shown to be a mean-reverting asset class (see this paper for detail). What does that mean? When volatility is higher than average, it s expected to come down. When volatility is lower than average, it s expected to move up. In other words, volatility moves towards the average. This is arguably the most predictable aspect of volatility. Why does this happen? Fear is cyclical. Fear and uncertainty don t last forever, and neither do periods of calm. When markets are in a state of fear, the particular concern always comes to pass. On the flip side, when markets are calm, there will inevitably be some future event that will bring fear back into the market. This will cause the VIX to mean-revert indefinitely. Volatility is volatile Take a look at a chat of the VIX it is very volatile. In fact, since 1990, the average daily move of the VIX has been 5.72 times larger than the average daily move of the S&P 500. Many see volatility (in this case, the volatility of volatility) as opportunity. This makes volatility a popular asset class among speculators.

4 Negative Correlation Historically, the VIX has a negative 80% correlation with the S&P 500. So, when the S&P 500 falls, the VIX tends to rise. This makes volatility great for hedging equity portfolios, and is a big reasons why volume in volatility products has been on a steady rise in recent years. See the chart below of the VIX relative to the S&P 500. Volatility Risk Premium (VRP) Just as there is a risk premium for taking on market risk (equity risk premium), there is a risk premium for taking on volatility risk. The volatility risk premium is represented by the tendency of VIX futures to over-estimate future spot VIX and implied volatility of S&P 500 index options to over-estimate realized volatility. When this premium is positive, it is paid by hedgers protecting their portfolios from downside risk and captured by those providing insurance to the hedgers (by being short volatility). Just as car drivers knowingly overpay for car insurance (as insurance companies are profitable as a whole), hedgers seem to be willing to persistently overpay for downside protection. In other words, hedgers are price insensitive when avoiding risk (especially true during market turmoil). As this is largely a human emotion, or even a necessity (ex: money managers who are required to hedge tail risk), we do not see this changing for the foreseeable future.

5 Not Investable Because the VIX is a derived value calculated from a range of option prices, it is not directly investable. In turn, volatility products, namely VIX futures (and ETNs based on futures) and VIX options were created to try to provide exposure to volatility. We ll explore each type of product below. VIX Products VIX Futures While spot VIX is not investable, VIX futures can be bought or sold directly, and they are primarily used for hedging or speculating. A VIX futures price represents the market s expectation for 30-day implied volatility on the expiration date of the particular future. For example, the July 15 VIX future is the markets expectation of what spot VIX (30-day implied volatility) will be at July s expiration date. There are several different futures contracts traded at any time (each one has a different expiration date). A graph of the different futures prices (like the graph below from is called the futures curve (the green dashed line in the below graph is spot VIX). There are a few important things to note about VIX futures. First, unlike S&P 500 futures (and many other futures) there is not an arbitrage relationship between the different futures contracts. In other words, there is no mathematical relationship tying the prices of different futures contracts together. Each month is independently an expectation of spot VIX on the expiration date of the particular future (expected spot VIX in June can be totally unrelated to expected spot VIX in September, for example). Second, as the VIX futures are expectations of future spot VIX, the futures curve generally prices in mean-reversion. For example, when the VIX is calm (mean-reversion would expect a higher VIX in the future), the futures curve is usually upward sloping,

6 meaning the market is pricing in a future increase in spot VIX. Moreover, after the VIX spikes (mean-reversion would expect a lower VIX in the future), the futures curve is usually downward sloping, meaning the market is pricing in a future decrease in spot VIX. This dynamic makes it difficult to trade mean-reversion in spot VIX (VIX Strategies has a workaround for this), and also generally makes the daily changes in VIX futures lower than the daily changes in spot VIX (because the market is already pricing in expected moves in spot VIX). As you can see, the shape of the futures curve is important. When the futures curve is upward sloping, it is said to be in contango; when it is downward sloping, it is said to be in backwardation (some people use slightly different definitions, but these are the definitions that we ll use). What does this mean for trading volatility? Let s pretend you want to short a recent spike in volatility (but remember, spot VIX is not investable) because you believe the event that caused the spike is overblown. After the spike in volatility, the futures curve would likely go into backwardation (like the graph below from How would this impact your short volatility trade (assuming you sell the front month VIX future)? Well, not only would you need spot VIX to drop in value, but you would need it to drop in value by more than what is already priced into the futures curve. So, you may often find yourself fighting an uphill (or downhill, depending how you look at it) battle against the futures curve. VIX Options Like VIX futures, VIX options are used for both hedging and speculating. VIX options are priced off of the corresponding VIX future (a 45-day option corresponds to a 45-day future, for example), not spot VIX. This can make VIX options look mispriced relative to spot VIX, which often leads to confusion for newer traders. Another trip up is that while VIX options are priced off VIX futures, the option settles into spot VIX. Further, because VIX options are priced off of VIX futures, you are often working against the futures curve. For example, after a spike in spot VIX, the futures will often go into backwardation. If you wanted to short volatility after a spike in spot VIX (to try to

capture the effects of mean-reversion, for example) you would be fighting an uphill (or downhill, depending how you look at it) battle against the futures curve (you want to be short but the futures

7 capture the effects of mean-reversion, for example) you would be fighting an uphill (or downhill, depending how you look at it) battle against the futures curve (you want to be short but the futures are already pricing in a drop in spot VIX). If you can get past the confusion, however, VIX options can be a great way to trade volatility with defined risk, and asymmetrical return profiles. VIX ETNs ENTs, or exchange traded notes (similar to ETFs), are investment vehicles designed to mimic an underlying index/strategy/commodity, and are structured to trade like stocks. This makes it easy for people to gain exposure to a particular index/strategy/commodity (not all people can trade on margin, for example, so trading futures may not be an option). There is no shortage of volatility ETNs available to investors/traders. Arguably, two of the most popular are VXX (short-term long volatility) and XIV (short-term short volatility). Understanding how these ETNs are structured is very important. VXX Below is a chart of VXX. As you can see, its value has steadily plummeted over the years. This has to do with how the ETN is structured. VXX holds a combination of the front two VIX futures. The two futures are weighted so that the weighted average represents a synthetic 30-day VIX future. Two factors lead to the longterm decay of VXX (as see in the above graph). First, the VIX futures curve is

usually in contango. Remember, each futures contract settles into spot VIX, and as each day passes, obviously, each futures contract gets one day closer to expiration.

8 usually in contango. Remember, each futures contract settles into spot VIX, and as each day passes, obviously, each futures contract gets one day closer to expiration. This causes the futures to pull to spot as they get closer to expiration (the gap between spot VIX and the future s price must close by expiration). So, when the futures are in contango, assuming spot VIX stays flat, each day the futures will lose value as they get one day closer to spot VIX. In other words, each day, VXX goes from representing 30-day volatility to representing 29-day volatility (a weighting adjustment is made at the end of each day to get back to 30-day volatility), and this action of rolling down the futures curve by 1 day, causes a drop in the price of VXX. The returns from the rolling down of the futures is called roll-yield (see more here). Second, the volatility risk premium (see the above section on VRP) causes VIX futures to overestimate future spot VIX. This generally creates extra drag, above and beyond the roll-yield, by being short volatility. These two factors have caused the long-term decay of VXX. XIV Below is a chart of XIV. As you can see, its value has steadily increased over the years (albeit with large drawdowns from time to time). XIV is structured the opposite way as VXX instead of being long a synthetic 30- day future, XIV is short a synthetic 30-day future. This puts the drag from the

9 roll-yield and the volatility risk-premium in the favor of XIV. This has caused the long-term rise in XIV (as shown in the above graph). In turn, strategies focused on trading XIV have become quite popular (the most basic is a long-term buyand-hold approach). As you can see from the above graph, however, XIV often has extreme drawdowns (when volatility spikes, it does so with force). In fact, drawdowns from an XIV buy-and-hold approach have reached over 90% in the past! This is why it is crucial to try to sidestep the spikes in volatility. Going about this alone, however, can be difficult. This is where VIX Strategies comes in. VIX Strategies We seek to add value above and beyond our benchmark, an XIV buy & hold approach, by considering the roll-yield, the shape of the VIX futures curve relative to spot VIX, and meanreversion of spot VIX, to help us decide when to switch from being short volatility to being long volatility. This has helped us reduce drawdowns as well as produce strong relative and absolute returns. VIX Strategies tracks two different strategies. Our first strategy, Roll Yield + VRP, considers the roll-yield and volatility risk premium to guide decisions, and uses ETNs (XIV and VXX) to gain exposure to volatility. Our second strategy, Mean-Reversion, utilizes option spreads to take advantage of mean-reversion of spot VIX. We also track a variation of the popular VRP strategies to understand what other traders are likely doing, and understand when our strategies might be in disagreement with these popular VRP strategies. Our strategies have outperformed a buy & hold approach on every level: higher CAGR, higher monthly Gain/Loss ratio, lower drawdown, higher best month, lower worst month, higher probability of success, and lower correlation with the S&P 500. Performance

10 Time in Position

11 Risk VIX Strategies are not without risk, however. To be clear, these are aggressive strategies meant for the aggressive allocation of one s overall portfolio (not meant as a standalone retirement strategy, for example). Monthly drawdowns can be quite large, and have reached over 50% in the past (although drawdowns for our strategies tend to be reversed fairly quickly relative to a buy & hold approach). In our opinion, the biggest danger to our strategies is the temptation to abandon the strategy after a large drawdown. In turn, we choose to stick to our strategies for the long-term, and avoid any urge to jump in and out of the strategy. With that said, from a monthly drawdown perspective, our strategies has historically been significantly less risky than a buy & hold approach that has experienced longer lasting and more severe drawdowns, that have reached over 90%

12 Monthly Returns Backtested Results VIX Strategies Roll Yield + VRP VIX Strategies Mean-Reversion Jan 14% 28% 15% 13% 12% 7% Jan 0% 0% 0% 27% 0% 0% Feb -2% 3% 14% 14% 19% -9% Feb 0% 0% -9% 0% 0% 0% Mar -10% 38% 21% 4% 8% 37% Mar 0% 0% 0% 0% 0% 0% Apr 23% -1% 1% 3% 17% 1% Apr 0% -3% 0% 0% 0% 0% May 7% -25% 1% 19% 12% 21% May 0% 24% 0% 0% 0% 0% Jun -2% 35% -1% 15% 0% -8% Jun 0% -23% 104% 0% 17% 0% Jul -2% 5% 31% -7% 6% Jul 0% 0% 0% 27% 0% Aug 74% 12% -14% 22% 31% Aug 0% 0% 0% 0% 7% Sep 36% 24% 8% -11% -4% Sep 0% 0% 0% 0% 0% Oct -18% -4% 21% 30% -6% Oct 0% 0% 39% 26% 0% Nov 2% 22% 14% 12% -3% Nov 0% 0% 0% 0% 0% Dec 17% -22% 8% 0% -24% Dec 0% 17% 0% 30% 0% Total 192% 144% 189% 180% 74% 50% Total 0% 10% 159% 163% 26% 0%

13 Other Popular Strategies VRP Benchmark XIV Buy and Hold Jan 14% 28% 6% -17% -17% -30% Jan 15% 31% 26% -17% -21% -22% Feb -2% 3% -29% -6% 29% 4% Feb 2% 5% -4% 9% 31% -6% Mar -3% 38% -7% 6% -5% 37% Mar -1% 37% 16% 1% 6% 37% Apr 23% -1% -7% 1% 17% -10% Apr 25% -3% -2% 4% 15% 1% May 7% -25% 1% 19% 12% 34% May 8% -25% -2% 19% 12% 21% Jun 0% 15% -7% 15% -7% -29% Jun -3% 27% -11% 15% -10% -21% Jul -17% -6% 31% -3% 21% Jul -13% 6% 35% -12% 18% Aug -9% 12% -14% 16% -52% Aug -51% 16% -13% 9% -47% Sep -28% 24% 8% -11% -2% Sep -30% 23% 14% -12% -5% Oct 15% -4% 8% 113% 28% Oct 20% -6% 8% -8% 28% Nov -1% 24% 8% 12% -3% Nov -13% 20% 13% 10% -4% Dec 16% -24% 6% -10% 6% Dec 14% -14% 5% -19% -14% Total 2% 82% -8% 146% -8% -14% Total -46% 155% 107% -9% -20% -3%

14 Live Results VIX Strategies Roll Yield + VRP VIX Strategies Mean-Reversion Jan 7% Jan 0% Feb -9% Feb 0% Mar 37% Mar 0% Apr 1% Apr 0% May 21% May 0% 0% Jun -8% Jun 17% 0% Jul Jul 0% Aug Aug 7% Sep Sep 0% Oct -6% Oct 0% Nov -3% Nov 0% Dec -24% Dec 0% Total -30% 50% Total 26% 0%

15 VIX Strategies VRP Jan Feb Mar Apr May 12% Jun -7% Jul 21% Aug -52% Sep -2% Oct Nov Dec Total -42% We started trading live in May At that time, we followed a VRP only strategy. After experiencing a drawdown in August 2015, we reevaluated our strategy, seeking to improve future results. In October 2015, we went live with our current strategy, Roll-Yield + VRP, which we believe is an improvement over a VRP only strategy. Our Roll-Yield + VRP strategy not only evaluates the VRP, but also the shape of the VIX futures curve relative to spot VIX (roll-yield) to make trading decisions. Follow Along If you would like help navigating volatility, we encourage you to follow along with our strategies by taking advantage of our introductory pricing. This pricing will be the lowest we will ever offer and will be limited to the first 100 subscribers. If you are not satisfied for any reason, you may cancel within the first seven days to receive a full refund. Find out more about the benefits of being a subscriber here.

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VIX Hedging September 30, 2015 Pravit Chintawongvanich, Head of Risk Strategy

VIX Hedging September 30, 2015 Pravit Chintawongvanich, Head of Risk Strategy P R O V E N E X P E R T I S E. U N B I A S E D A D V I C E. F L E X I B L E S O L U T I O N S. VIX Hedging September 3, 215 Pravit Chintawongvanich, Head of Risk Strategy Hedging objectives What is the