Article #555) Volatility / VXX spikes - How can we reduce the risk?

VTS Community,

Yesterday turned out not to be that bad a day considering how it started.  S&P 500 futures were down as much as -2.2% in the early going, but by the days end the S&P was only down -0.45%.  However, for anybody that was excited about the turnaround, today is again attempting to spoil what was not yesterday with the S&P down -1.3% as I write this.

I had a few emails about my short volatility trades and the potential damage.  Now it was just a few emails, it's more when markets are all out crashing, but that's to be expected during down days like that.  Short volatility trades can go up or down a lot quicker than the overall stock market can.

That is called Beta, when measuring the movement of one instrument vs another.  Spoiler, a few of the metrics to be added to the Volatility Dashboard are Beta related so stay tuned for those.  But because short Vol Beta is so high, these positions need to be managed very conservatively.  

First, let me remind everybody of the magnitude and frequency of bad days for short vol traders, and then I'll give a few tips how to navigate going forward.

Those are the 25 largest VXX spikes since the volatility ETP market launched on Jan 30, 2009.  Days like Feb 5th, 2018 don't happen very often, that was a once per decade type of event, but VXX spikes on the order of 13-20% happens fairly regularly.  And while I personally have a very good track record of avoiding the vast majority of them, unfortunately in trading you can't avoid em all.  I'll repeat that more directly to drive the point home. 

If you're going to be trading volatility ETPs, it's a near certainty that at some point you will have a few really bad days.

It just comes with the territory.  You can't have all the benefits of an underlying instrument capable of making 50% or more in a single year, without also having the potential for quick and ugly rude awakenings.  So all we are left with is tools to help us mitigate the damage to the least possible amount:

1)  Always heed volatility metrics warning signs and move to safety that day!  I can't tell you how many times I've heard people speaking regretfully about how they knew there was trouble brewing, but they held on just a few days more to see if it would recover, and oops.  Don't be that trader.  If volatility metrics  (VTS Volatility Barometer, Volatility Dashboard, or my direct trade signals)  say there is a warning, then there is a warning.  I can't tell anyone what to do, I can't make any personalized investment advice, but I would "invite" you to heed those volatility metric warnings and move to safety when they arise.

2)  Allocate conservatively.  Given the explosive growth of some of these volatility ETPs and the "short vol" trade, it's natural to be tempted to allocate more capital to them.  Trust me, I feel it too.  We're all human, and we all see those dollar signs flashing in our eyes sometimes.  I've pulled in over 50% a year on average trading these products over a period of many years.  I was one of the first adopters, one of the first short vol ETP bloggers, and not to toot my own horn but I doubt many have had more success at it.  Having said that, I still only allocate 20% of my portfolio to these strategies.  And, that 20% is divided among 3 lesser correlated strategies to further diversify.

I don't care how well I do with them in the past or going forward, there is a hard line built with a brick wall at the 20% portfolio allocation.  And with discipline, that wall mine as well be stacked to the heavens because it can't be breached.

3)  Conservative strategies.  Currently the VTS family of volatility strategies includes three.

VTS Tactical Volatility  (VXX puts, cash, VXX calls) VTS Conservative Vol  (ZIV, cash, VXZ) VTS Aggressive Vol  (SVXY, cash, VIXY)

There are a few basics that apply to all of them.

-  No margin is used, and no leveraged products are used, ever -  All of them have healthy amounts of cash positions -  All of them have potential bear market positions -  All of them have the ability to move to safety on a 1 day notice 

4)  Constant portfolio rebalancing.  This is a big one.  Since we know that despite having great indicators to avoid most of the damage, the occasional bad day can slip through at any time.  It's a good idea to always maintain the roughly 20% portfolio allocation  (or whatever yours is)  going forward.  If a trader just allocates a certain block of capital to a volatility strategy and lets it run independent of the broad portfolio, after a few successful years it could be substantially higher.  Yet, since drawdowns work in percentages, a bad day can wipe out a lot of that capital.  A day on the order of magnitude of Feb 5th, 2018 can take nearly all of it.

I constantly rebalance my volatility strategy capital with each new trade in relation to my overall investment portfolio capital.  So every time I sell a position and open a new one, I allocate the desired amount of capital to that new trade.  If it's 6.7% of total capital, every new trade gets 6.7% of my overall capital.

That way I'm essentially constantly realizing the gains going forward and adding that capital to my portfolio, rather than compounding it independently.  If something were to happen say in 2020 that cost me far more than I was comfortable losing, it would definitely hurt, but it wouldn't cost me all the gains I made from 2010-2019.

We can't eliminate risk, we can only mitigate it:

1)  Heed volatility metric warning signs and exit that day. 2)  Allocate conservatively, no matter how successful you are. 3)  Trade conservatively, no margin, no leveraged products. 4)  Constant portfolio rebalancing to realize gains as you go.

With these tips  (and with a lot of guidance from the Volatility Barometer and dashboard)  I'm confident we can all navigate this space as safely as possible, while still leaving some room for the occasional monster year which is always fun when it happens  :)

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