E 2018 Market Volatility And Volatility Trading Update

Higher Volatility Regime

There is a difference between elevated volatility in the markets and volatility remaining elevated. Unfortunately, the media and mass investor population overlooks the distinction. Volatility or the VIX can be elevated versus the previous year, but still hold true to its nature, which is to rise for brief periods of time and fall for longer periods of time. 2018 is a perfect example of this explanation whereby the VIX rose sharply in February and has remained higher on average when compared to 2017, but still trending lower since February.

So what does that mean for volatility traders and the short-VOL trade given that volatility has elevated in 2018? What we decided at the end of 2017 was that it would probably be advantageous to forgo the usage of 2X-leveraged VIX-Exchange Traded Products. In 2018, Golden Capital Portfolio transitioned most holdings from UVXY to VXX. The VXX product is not leveraged like UVXY and as such, should a VIX event occur as it did in February, the drawdown on holdings would not be significant. The plan worked rather well given the February “Volpocolypse”, as it’s now referred.

Trading volatility requires or demands vast experience in the market, a fundamental dedication to macroeconomics, following earnings cycles and more. In short, trading volatility shouldn’t be viewed as a part-time job if that is in fact a main strategy one employs for investing and trading purposes. For those who do not have the time or ability to dedicate such time, but still desire to achieve outsized returns from the trade, mentors are available and can lend expertise to curtail time allocations.

Given the Volpocolypse that occurred in February and resulting in the termination of XIV and lowered leverage for several other VIX-ETPs, what’s next for trading volatility? That’s where market experience comes into play. Yes, we are likely in the latter innings of the bull market and economic expansion, but that does not mean markets will begin to falter or volatility will remain elevated. And even if markets falter and volatility rises for brief time periods so what. Why “so what”?

Let’s face it, recessions, bear markets and even corrections are very brief when compared to economic expansions and bull markets. In fact, expansions and bull markets are often triple and even quadruple the duration of the former conditions. So what is the job of a short-VOL trader and/or investor? That’s right; simply maintain liquidity to preside over the duration of the trade. It’s only a matter of time when shorting volatility. Time can be measured in terms of cash liquidity in ones brokerage account.

Additionally, while markets can trend lower, the VIX correlation to the market is not a perfect 1:1 correlation. Markets can decline with the VIX also declining and visa versa. The fact of the matter is that the market can’t sustain a constant elevated reading of volatility or "elevatING" of volatility, as investors would simply leave the market in droves. We have seen this for decades and most recently in the February 2018 period where the VIX briefly touched 50 before faltering, even as the market trended lower. The VIX fell quite substantially as the market dipped further and only sustained itself above the 20% level for less than 4 weeks before falling below this historical median average of the VIX (19%-20%). It's also important to note that the historic average VIX reading is not without extrapolating for major spikes like that of 2008, 2011, 2014, 2015 and 2018.  If we do extrapolate these spikes of significance, the true average is much less than 19-20% and probably closer to 12-14 percent,. 

Moreover, the VIX is often found as a hedging instrument as institutional investors seek to offset declines in the equity market commonly associated with elevating volatility/VIX levels. But there is a point when such a hedge becomes too expensive in terms of risk/reward provided through the VIX hedge (Volatilty Risk Premium). Generally, the VIX doesn’t maintain itself above or in the mid-20s for very long as this is considered an expensive level to hedge within the VIX complex. As such, even though the market (S&P 500) may still be declining, the absence of hedging through .SPX options expresses a declining value in the VIX. Subsequently as the VIX declines, derivatives (VIX options, futures, VIX-ETPs) within the complex also lose value or decay in price.

Actively Trading VIX-Exchange Trade Products

More importantly, as it pertains to trading volatility, are the products one uses to trade volatility. Inverse VIX-ETPs, those that trade inversely to the VIX itself (VIX goes up, VXX, UVXY, TVIX, VIXY go down/decay) will decay in value over time. Such decay is based on the ETP’s correlations and composition of VIX futures as well as the general understanding that public equity markets will always exist. Based on the decay factor, these instruments are used directly in short participation and theory as to shorting volatility. One can use options, buy puts in certain of these products, but it’s likely more advantageous to sell calls and avoid what can occur with VIX-ETPs and is known as “theta decay”.

Options are a way to manage risk in the volatility complex, although it does come with other debatable risks such as post and premarket hour trading risks. Obviously, one cannot trade option positions during premarket and post market-trading hours. Unfortunately, many market related events can and do take place during such hours that leave a trader lacking for risk mitigation from either side of the trade. Remember, if the job of the trader is to maintain liquidity, but certain market events during untradeable hours expose an option to be put or called at max loss/risk exposure, the liquidity aspect of the trade can be nullified greatly (and where will the option be put or called away is an unknown aspect leaving a trader without being able to fully define account liquidity). It’s just one of the many reasons Golden Capital Portfolio prefers the usage of common shares despite where the greater trading takes place, in the options market. Having said that, it may also identify one of the underlying reasons Golden Capital Portfolio has managed well through the various VIX events over the years. Moving on…

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