Volatility Traders: Beware

07/25/2013 8:00 am EST

Focus: OPTIONS

Jared Woodard

Principal, Condor Options

In an environment of rising rates, low-to-moderate global growth, and fairly priced option implied volatility, simplistic short volatility strategies will probably not perform as well as they have in the last few years, writes Jared Woodard of CondorOptions.com.

After the financial crisis, there were fewer asset classes that people were willing to describe as diversifiers. They were/are:

1. Managed futures, which generally just means long/short    commodity trend-following
2. Fixed income, but really just US Treasury bonds and notes
3. Option implied volatility
More on that last item in a moment.

The notion of commodities being treated as a separate asset class has always seemed a little strange. It’s not as though commodities are sui generis economic Robinsons Crusoe. Many of them are crucial inputs to the real economy; for some analysts, the energy complex is the master signifier through which the book of the world may be read. But then why should we think that owning coffee futures will hedge our Starbucks shares or that jet fuel contracts will have salutary effects on the efficient frontiers of portfolios that already include shares, e.g., of airlines? The claim that commodities might provide better risk-adjusted returns than various downstream equity cousins is part of a different (and false, I think?) argument; my point here is that it’s not intuitive or obvious why commodities, as a class, would be naturally uncorrelated to stocks, especially during a financial crisis or any deflationary shock. And it’s an admission of defeat to say that the long/short aspect of trend-following managers is what provides the diversification, since of course a set of winning trend-following long/short rules would also serve nicely if applied to stocks.

The ten-year note has caused a lot of firms a lot of heartburn over the last month or two, but I don’t think any of that is relevant to the question of crisis hedging. In a crisis, people are really eager to own US government debt. It was funny, in retrospect, how during the debt ceiling foolhardery in 2011 investors actually ran toward the Treasury. For our purposes, the income matters a lot less than the lack of credit risk, so diversifier #2 is really just cash plus whatever yield you accept in exchange for liquidity.

That leaves option implied volatility as the only non-cash safe haven in a storm. The popularity of VIX-based hedging vehicles and of the notion of volatility as an asset class suggests that many investors have been persuaded of the value of volatility products. The cost of owning options vega and the importance of the implied volatility term structure were not well-known by most investors before the financial crisis, and products like VXX have been educational in that regard.

But something that Russell Rhoads at the CBOE mentioned last week reminded me of a worry that has been on my mind over the last several months. Since 2009, it has become popular among investors who were not already options traders to be constant sellers of implied volatility by being short VXX, or long XIV or ZIV, or less frequently by selling VIX futures. I’ve seen more than a couple rules-based long/short strategies appearing on blogs using volatility ETP data from the last few years. It’s worth noting that we have not yet seen what a real crisis looks like in the presence of liquid and actively traded volatility products. “In 2008,” Russell notes, “before VXX was available for trading, VIX was in backwardation about 40% of trading days. Another period of time like that and VXX will benefit from the combination of higher VIX and backwardation.”

The worry is that the decline in option implied volatility from the extreme heights of 2008, combined with the coordinated salvific efforts of central banks around the world, makes the volatility time series from 2009-2013 essentially one big data point. The worry is that strategies tested over that period might use daily data, but that their sample size, really, is n=1. We can call it a volatility “regime” if we want to be a little more grand, but the point is that an environment of rising rates, low to moderate global growth, and fairly—rather than extremely over—priced option implied volatility means that simplistic short volatility strategies will probably not perform as well as they have in the last few years. I think this fits in with the overconfidence of passive indexers and with the ETF-ization of everything: the moment when the consensus approach is to mock hedge funds as a group and to assume that all of the important aspects of an asset class can be captured in an ETF is probably also the moment when the crowd starts lagging more sophisticated investors.

By Jared Woodard of CondorOptions.com

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