On The Long Volatility Trade
We often think of volatility ETPs (e.g. UVIX, VXX, UVXY) as an insurance products. They are: no doubt about that. But let’s imagine we are experiencing a period of recession like December 2007 to June 2009, if we would have been long the VXX (assuming it existed), we could have profited by ca. 50% while the S&P500 dropped by ca. 40% in the same timeframe.
Free lunch? Not quite. We would have experienced a double dip drawdown of ca. 35% around May and August 2008 and at this point I am convinced that many investors in the heat of the moment would have thrown the towel. For the ones with a titanium-like risk tolerance, even if they would have perfectly timed the market, they would have experienced a ca.55% overall drawdown.
We need to be smarter than that. Because in my opinion investors (the ones investing a large part of their net worth in the financial market) can tolerate at most 10-15% maximum drawdown.
How to get there? VXX like ETPs derive their values based on the first two front months of the VIX term structure (http://vixcentral.com/). Understanding how these two numbers move relatively to each other and relatively to the equity market volatility (VIX) can give us an insight on the most probable movement of VXX like products. By doing so, during the 2007-2009 recession we could have boosted the return of our insurance product from ca. 50% to 130%. The drawdown would have been reduced from ca. 55 to 28%; see VXX Tactical line. Personally I am risk-phobic and over the years I have learned that my threshold pain is at 10% maximum drawdown. When I open a long vol trade, I tend to do it while allocating only part of the capital depending on the position of the first two front months of the VIX term structure. By doing so, I am able to control (in theory, we never know of future events) the max drawdown to ca. 10% (see VXX NEXT-alpha) while getting decent return on the investment.
Over the last 18 years, this strategy would have performed nearly as good as buying and holding the S&P500 but with lower drawdown and higher Sharpe Ratio; see chart below. The strategy would have behaved particularly well during the March 2020 crisis. Pity that at that time it was not a part of the portfolio. I am convinced the chance will represent itself.
In conclusion, going long on volatility is a tricky trade but if properly calibrated it can provide a hedge during violent market pullbacks. I personally like this trade and it is part of my NEXT-alpha portfolio because in my opinion it provides a strong hedge when the fear in the market is elevated and a major sell-off has started.
This is how I hedge my portfolio. How do you do it? Comment below.