Quant Lab
Smart Volatility Investing
Tages Capital
39 St James’s Street, London, SW1A 1JD
T: +44 (0)20 3036 6051
www.tagescapital.com
[email protected]
Authors
Berouz Fatemi, Portfolio
Manager, Tages Capital
Sébastien Krol, Portfolio
Strategist, Tages Capital
Overview
The purpose of this report is to introduce the notion of ‘Smart Volatility’.
The concept is gaining ground as more investors look for strategies to
hedge against tail events which have better risk/reward profiles than
long options exposure.
Holding options can be an expensive exercise over the long run.
Investors have tried to time the purchase of volatility to minimise these
costs, but long term analysis shows that even good timing has failed to
markedly improve the performance record of such opportunistic buying.
Some of the basic characteristics of the options markets such as
momentum in volatility, rising skew in times of crisis, etc. can be utilised
to build systematic models to assist investors with the question of timing
entry and exit points.
Other relative value Smart Volatility strategies provide investors with
long volatility and convexity exposure at relatively modest costs. These
strategies should be considered as part of a diversified tail-hedge
strategy.
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Section 1:
Volatility used as a hedging instrument
Implied and realised volatility
Over the years, investors and speculators have been Implied volatility: This is the market forecast of
trading options on various underlying instruments future realised volatility; it is a forward looking
with the aim of realising gains when markets move measure which is inferred from the Black-Scholes
in a certain direction or profile. The trading of equation based on the prices of traded options.
volatility provides a direct way to capitalise on
uncertainty in financial markets, with volatility Historically, implied volatility tends to act as a
increasing in line with market stress. biased predictor of realised volatility, and tends to
trade at a premium to the subsequent realised
Before delving too far into the practical trading of volatility, as shown in the figure below for the SPX.
volatility, it is important to distinguish between
More recently, VIX futures, options and exchange
realised volatility and implied volatility.
traded notes (ETNs) have been utilised to trade
expectations of stock market volatility in the near
Realised volatility: This is the standard deviation of
future.
price returns; it is a backward looking measure
The current VIX index value quotes the expected
considering the path behaviour of the stock price
realised volatility of the S&P 500 index over the
over the history of the volatility window.
following 30 days, and is calculated by using the
mid-point of real-time S&P 500 index option bid/ask
quotes.
Fig 1. VIX vs. S&P 500 Realised Volatility
Source: Bloomberg
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Section 1:
Volatility used as a hedging instrument
Negative correlation to equity returns
The feature that makes VIX or volatility in general The behaviour of implied volatility tends to be
attractive to investors is its negative correlation to strongly negatively correlated to market movement.
equity returns. As equity markets decline, equities As shown in the figure below, market uncertainty
tend to become more volatile. Hence, the VIX tends tends to increase in times of market stress for the
to rise as the market anticipates increased future VSTOXX index (equivalent of VIX for European
volatility. stocks) vs. the Eurostoxx50 index.
Fig 2. Eurostoxx daily return vs. V2X daily change
Source: Bloomberg
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Section 1:
Volatility used as a hedging instrument
Large spikes for significant equity losses
Volatility expectations tend to spike after large sell- market is rising. This makes the VIX potentially
offs but gradually move down in a rally. This is attractive as a tail risk hedge, due to its negative
consistent with investor behaviour – they are more correlation and its convexity to large negative
anxious to purchase protection when equities are equity returns.
falling than they are to sell volatility when the
Fig 3. S&P 500 vs. VIX
Source: Bloomberg
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Section 1:
Volatility used as a hedging instrument
Time decay
The most expensive times to own insurance against exposure to a daily rolling long position in the first
a U.S. equity crisis were, not unexpectedly, the and second month VIX futures contracts.
periods surrounding the global financial crisis
(2008), the flash crash (2010), the Greek debt crisis The ever-widening spread between VIX and VXX is
(2011) and the ‘Vixmageddon’ in February 2018. the cumulative cost of the regular roll-down, often
This pattern illustrates why the VIX is often referred referred to as the decay. Unfortunately, as clearly
to as the ‘fear index.’ However, it is more useful to illustrates here, a long-term allocation to a static
think of the VIX as the current cost of the insurance volatility holding is a drag on a portfolio. In the case
premiums. The actual, investible volatility assets of VXX, the long-term drag amounts to an average
most closely related to the VIX are VIX index futures of 13 bps per day.
and VXX. The VXX is an ETN designed to track VIX
futures. Investing in VXX is essentially equivalent to
Fig 4. VIX vs. VXX
Source: Bloomberg
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Section 2:
Buying volatility or put options
Betting on increased volatility
Many investors use put options to hedge their
portfolios. Some investors prefer to purchase
volatility in the shape of options that they
regularly delta hedge, or by just buying VIX
futures, trying to benefit from a jump in S&P Fig 5. Options volatility as a function of gamma
volatility regardless of the direction.
The P&L of volatility trading through delta-
hedging options is a function of the gamma (or
option curvature) and spread between implied
and subsequent realised volatility:
One of the main problems with trading volatility
Fig 6. Option strike price and Gamma
through vanilla options directly is the changing
exposure to the volatility of the product as the
underlying moves away from the strike. Due to
gamma acting as a scaling factor, and ATM
options having the highest gamma exposure, the
P&L sensitivity to volatility falls as the option
moves away from the ATM strike.
Source: Tages Capital
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Section 2:
Buying volatility or put options
Timing volatility
Unfortunately, due to the difference between The below chart demonstrates the average annual
implied and realised volatility, as well as the time return of a long volatility strategy for different
decay involved in owning options, the practice of deciles of S&P volatility increases from 1999 to
owning options ends losing money about 70% of the 2019:
time. In fact, the only time one might benefit from
owning volatility as a hedge is when volatility
increases significantly.
Fig 7. Average annual return of a long volatility strategy
Source: Tages Capital
Even when volatility is on the rise as above, an Additionally, the time decay forces one to time the
investor, on average, benefits only during the most entry and exit of such transaction quite accurately
volatile decile. So not only does one need to know as, on average, about 20 days after the first spike in
when volatility is on the rise, but one must buy volatility, gains start diminishing quickly.
volatility only when the expected rise is to be
significant. This exercise seems quite unrealistic.
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Section 3:
Smart Volatility
Concept
Smart Volatility strategies are essentially rule-based As referenced above, Smart Volatility strategies can
trading strategies whose objectives are to capture a be roughly divided into two categories:
specific part of the performance sought by active
• Market-timing type strategies assisting with the
volatility managers. These strategies can either be
issue of timing by providing systematic exposure
designed to be hedging strategies or alpha
to volatility using certain basic rules based on
strategies, and they seek to improve performance
the most common characteristics of the options
as it relates to the aforementioned timing
markets.
difficulties, as well as to help optimise the strategy
• Relative value strategies benefiting from market
weightings.
inefficiencies to provide cheap optionality. Such
Smart Volatility, effectively, is to active and passive
strategies typically consist of purchasing more of
vol strategies what Smart Beta is to active and
relatively cheap options against overvalued
passive long only strategies. Like Smart Beta, Smart
options. Investors have the opportunity of
Volatility strategies tend to be a very liquid and
designing such strategies according to their
relatively inexpensive way to take advantage of
preferred outcome in different market
perceived systematic biases or inefficiencies in the
conditions.
market.
Fig 8. Comparing smart volatility to smart beta strategies
Source: Tages Capital
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Section 3:
Smart Volatility
Options markets characteristics
Most options markets share the below features ▪ Options exhibit a degree of momentum, or self-
which can be employed in building market-timing correlation. Simply put, when volatility is
models to assist with the problem of timing options increasing, it has a slight tendency to continue
transactions: increasing and vice versa.
▪ The price of vol is all relative. Contrary to most ▪ Volatility is mean reverting in nature. It tends to
people’s initial intuition, a ‘high’ price does not trend over short time horizons and reverts over
necessarily mean ‘overpriced’ and a ‘low’ price longer periods.
does not necessarily indicate ‘under-priced’.
▪ Skew, term structure and convexity can also
Instead, we must compare the implied volatility
have predictive characteristics. It is important to
(as indicated by the market price) versus its own
analyse which area of the volatility surface looks
history, or the realised volatility of the
most attractive. As an example, a steeper put
investment universe in question.
skew denotes a larger demand in downside
protection.
How to build a Smart Volatility signal
We can use the above factors to build a simple In the below example, we observe the spread
systematic model. For each factor, we observe the between 1-month S&P 500 implied and realised
z-score to measure relative cheapness, we check volatility, and measure this versus the rolling 1 year
the predictive power of a potential signal, and we two standard deviation level. From this, we can see
then test the signal to measure its effectiveness. that it seems to make sense to buy implied vol when
it is below realised vol.
Fig 9. Implied Realised Vol & Rolling 2 Std Dev Signal
Source: Tages Capital
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Section 3:
Smart Volatility
How to build a Smart Volatility strategy
We then need to determine whether two standard
deviations is the appropriate trigger level. The Fig 9. Factor: implied realised spread
below scatter plot demonstrates the relationship
between the z-score of the S&P implied-realised vol
spread and the subsequent performance of VXX.
As shown by the highlighted area below, when
implied volatility is relatively cheap (negative z-
score), the returns tend to be more positive.
Finally, we test the results. The distribution plot
below shows the VXX returns when the z-score is
extreme. Thus, this signal would be deemed a good
candidate for our systematic test model.
Source: Tages Capital
Fig 10. Implied Realised Vol & Rolling 2 Std Dev Signal
Source: Tages Capital
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Section 3:
Smart Volatility
Example Smart Volatility strategy
We now want to show a simple example. We ▪ In order to produce a Smart Volatility strategy
apply the Smart Volatility concept to VXX using with a comparable structure and volatility to
just two signals to build a systematic model. In the reference strategy (long VXX), we have
our example, we will use the signal explained on structured our Smart Volatility strategy to be
the previous page, and combine this with an long only and with a gross exposure to VXX
additional signal looking at skew (vol smile). of not more than 100%. In addition, we have
assigned a 50% weight to each signal when
▪ The first signal is based on the cheapness of
activated.
S&P implied to realised volatility. The
indicator provides a buying signal when the Below, you can see the results of our Smart
z-score hits two standard deviations. Volatility strategy versus a typical VXX
allocation (25% long, again to ensure we are
▪ The second signal is based on the ratio of
comparing strategies with similar risk profiles).
S&P 500 At The Money volatility versus put
volatility. A VXX buy signal is produced when This simple exercise demonstrates how some
downside volatility rises more than two simple factors can assist in building a model
standard deviation relative to ATM volatility. which can outperform the outright purchase of
VXX.
Fig 11. VXX vs. Smart Volatility basic strategy
Source: Bloomberg, Tages Capital
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Section 3:
Smart Volatility
Relative value strategies
In addition to models structured to optimise the opportunity over prolonged periods.
timing of options strategies, there are many other
▪ Dispersion trades
Smart Volatility strategies, which offer cheap
This strategy involves the purchase of options on a
optionality and convexity. Here are a few examples:
number of single stocks against selling volatility on
▪ VIX vs S&P options
the basket itself (or, as an example, buying the
Combination long VIX and long S&P due to the options on a number of single stocks in the S&P and
negative correlation. This strategy has produced a selling the vol on the S&P index). With the
positive track record with the exception of Q4 2018 diversification effect, the index usually has a lower
when the beta of VIX futures relative to the index realised volatility than a collection of single names,
itself collapsed. the strategy acts as a long volatility strategy
especially in bear markets. This strategy could be
▪ S&P options Vs EuroStoxx options
implemented in vega neutral, theta neutral and
At times, the flow in options markets tends to
other combinations, which provides the investor
depress implied volatility in one market relative to
with a defensive or carry profile.
other markets. These anomalies can last for a few
months or years and can be a cheap source of
optionality.
▪ Skew or term-structure spreads
Flows and investor behaviour can often create
opportunities for relative value strategies across
different option tenors (three month vs one year,
for example) or across the volatility surface (ATM vs
OTM options for example). Such situations can
provide the investor with cheap protection or alpha
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Section 3:
Smart Volatility
Relative value strategies
The below picture includes performance of some of combination of those systematic strategies could be
the above strategies against S&P puts. It is clear that a very cost effective tail-hedge solution over
most have demonstrated varying degrees of medium to long term.
positive returns during the periods of crisis. A
Fig 12. Relative value volatility strategies vs. S&P Puts
Source: Tages Capital
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Conclusion
The concept of Smart Volatility is at the heart of our Paladin UCITS Fund. The Fund is
structured to provide a multi-asset hedge against tail type events, by combining
relatively inexpensive Smart Volatility strategies with trend, mean reversion and very
low beta carry strategies. We perform various quantitative and qualitative analysis on
each of the sub-strategies to ensure their robustness. And we diversify and update the
models we use in the portfolio on an on-going basis. This latter point should not be
under-estimated as systematic signals tend to have a limited life span. As a
consequence, we believe accessing a portfolio of such strategies is best done through
an experienced portfolio manager.
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