Eight Ways We Manage Risk

Jason MacArthur I November 28, 2017

If you ask successful traders to list important components of their success, undoubtedly, risk management would be near the top of that list. Risk management is therefore a key focus in the design of our VIX strategies.

In this brief article I highlight eight ways we mitigate some of the risks associated with trading volatility Exchange Traded Products (ETPs). It is important to note that volatility trading involves considerable risk, and while our strategies use a combination of the approaches presented here, risk can never be eliminated. This list is also not exhaustive and others may use some quite different approaches.

1. Keeping the Volatility Risk Premium (VRP) in Our Favor

All of our strategies seek to harvest the Volatility Risk Premium observable in the VIX futures – and it is this premium that contributes the bulk of our returns. As a reminder, VRP stems from the premium hedgers pay for S&P 500® Index options over the volatility that the S&P 500® ultimately realizes. Because the VRP may be positive, negative, or even neutral, its direction and magnitude can provide clues to the performance of VIX ETPs like VXX and XIV. For example, an inversion in the VIX futures term structure in the first two months has corresponded to subsequent extended drawdowns in XIV.

Our approach is therefore to adjust our positions based on the direction and magnitude of the VRP, always trying to keep it in our favor. However, it is important to note that the VRP is notoriously difficult to measure, so we look at the various relationships between VIX futures, the VIX index, and realized volatility of the S&P 500 for indications of its level.

2. Being Reactive Rather Than Predictive

No one knows the future, and trying to predict the direction of volatility may prove nothing more than a risky guessing game. For example, imagine the roller coaster ride of trying to use the VXX to take advantage of the short lived and sporadic spikes in volatility this year. From the chart of the VXX below, it’s clear how anyone trying to capture those five or six spikes in an otherwise falling VXX market would have to have been very lucky indeed to have finished profitable.

Instead of trying to predict movements in volatility, it may be more reliable to react to changes in the VRP. By reacting to changes in this premium, and always keeping it in our favor, we try to improve our risk-return.

3. Reducing Overnight Exposure

XIV has a termination event clause that allows the note to be terminated if it experiences a daily loss (measured from the prior close) of greater than 80%. The probability of this termination occurring may perhaps be highest when the VIX is near the low end of its historical range. One way to reduce some of this risk is to avoid adverse overnight moves by reducing overnight exposure. It is important to remember, however, that avoiding overnight exposure can increase trading costs, and fails to capture any favorable overnight moves.

4. Utilizing Intraday Stop Loss Orders

Incorporating stop loss orders into a trading strategy can help avoid extreme downturns. However, it is important to remember that using stop loss orders can also adversely affect performance during a reversion. For this reason, we consider stop loss orders only as a “backstop” to protect us against extreme adverse intraday price moves.

5. Being Systematic

Every time we have to make a new decision, we open ourselves up to making a mistake. Having a systematic, or rules based, trading approach reduces the emotional and human elements in these decisions, and potentially eliminates an important risk factor. Maintaining this discipline over the long term could make the difference between a profitable investment and a costly mistake.

6. Scaling Exposure

Varying the size of a strategy’s volatility exposure may be just as important as keeping the Volatility Risk Premium (VRP) in our favor. During periods when the VRP is large and in our favor we may increase our exposure, and when the premium shrinks we may reduce exposure. Using this approach gives the strategy a risk adjusted exposure to the VRP, taking most risk when the probability of a large positive outcome is highest.

7. Maintaining a Long Term Perspective

Volatility trading strategies can produce volatile returns, and drawdowns are inevitable from time to time. Designing a strategy that is prepared for these moves and that is able to stick to a system over the long term may avoid the risk of getting shaken out at the worst possible time – usually during a drawdown. While our strategies seek to reduce the magnitude and duration of drawdowns, we accept that they will occasionally occur and encourage investors to take a medium to long term approach in their volatility investment philosophy.

8. Diversifying

Finally, and perhaps most importantly, not all VIX strategies are exposed to the same risks, and each has its own set of strengths and weaknesses. These differences can lead to significantly different performance across varying market conditions. Diversifying across uncorrelated volatility strategies may therefore help mitigate some risk factors, reduce drawdowns, and improve overall risk-return.

There are numerous factors that a volatility strategy can diversify across, but here are a few factors we choose to focus on. Again, this list is far from exhaustive.

a) Trade Structure

Some strategies hold overnight positions while others intraday only. Balancing between the two approaches could help optimize the amount of overnight risk an investor wishes to be exposed to.

b) Signals

When seeking to harvest the VRP, the signal and method used to determine the direction and level of the VRP can significantly alter a strategy’s performance. For example, some strategies may focus on the slope of the VIX futures curve, while others may focus on the spread between the futures and spot VIX, or the spread between expected and realized volatility.

c) Scaling / Allocating

Different strategies may have different levels of exposure to VIX ETPs at various times. Some maintain a relatively static allocation to the ETPs, whereas others may reduce exposure following profitable runs. A blend of these approaches can be important in optimizing a VIX strategy.

Furthermore, there may be advantages in diversifying across volatility strategists as well. This is the approach we take at Invest In Vol. Invest In Vol is a Registered Investment Advisor offering the diversification of three leading volatility strategists in one managed account. By combining three distinct strategies from three independent strategists, Invest In Vol seeks to dampen drawdowns, and deliver more consistent returns than other trading strategies.

About the Author

Jason MacArthur, CFA, has been studying, developing, and trading investment strategies since 2007, and has focused on volatility strategies since 2011. Jason has a passion for helping others succeed in financial markets, and founded the online signals business VIX Strategies in 2015 to help educate investors on trading volatility. Jason has further experience in fixed-income portfolio management, and with advising on mergers and acquisitions. Jason graduated summa cum laude from Washington State University with a BA in Business Administration. Jason MacArthur is independent of Invest In Vol, LLC.

Disclosure

This is not, and should not be considered investment advice. Investing involves risk, including the possible loss of principal. Carefully consider the Strategy's investment objectives, risk factors, charges and expenses before investing. This Strategy is actively managed and there is no guarantee investments selected and strategies employed will achieve the intended results. The Strategy is not diversified, and narrowly focused investments may be subject to higher risk. Strategy is subject to change.

Past performance does not guarantee future results. This information has been provided by Invest In Vol. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This is not to be construed as an offer to buy or sell any financial instruments and should not be relied upon as the sole factor in an investment-making decision. References to specific securities and their issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. The views and opinions expressed are those of the portfolio manager at the time of publication and are subject to change. There is no guarantee that these views will come to pass. As with all investments there are associated inherent risks. Please obtain and review all financial material carefully before investing. Investments are subject to change without notice.


For a more complete disclosure please visit www.investinvol.com/disclosure.

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Investing involves risk, including the possible loss of principal and fluctuation of value. Past performance is no guarantee of future results. Carefully consider the investment objectives, risk factors, charges and expenses before investing. Invest In Vol, LLC is the investment advisor for the separately managed accounts (SMAs) and advisory services; it provides investment advisory services to clients and does not sell securities. For a more complete disclosure & definitions click here. For a more complete description of our business, Form ADV 2A, and accompanying brochures, click here.

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