Structural Arbitrage: Making Money With Math

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 |  Includes: TMF, XIV, ZIV
by: Harry Long

Summary

Structural Arbitrage can be implemented with mid-term volatility.

Our public strategies should be starting points for further investigation.

There are numerous extensions to Structural Arbitrage.

It's time to head to the beach and to enjoy the profits.

You take the blue pill -- the story ends, you wake up in your bed and believe whatever you want to believe. You take the red pill -- you stay in Wonderland, and I show you how deep the rabbit-hole goes.

--Morpheus, The Matrix

This Summer, I was clear that making money with math has been too easy for too long, and that it is time to enjoy the profits. I encouraged readers using our simple public strategy indices to close out their positions and join me on the beach -- literally, figuratively, and financially.

Since then, I have heard from numerous readers who are heedless of my warnings. Some are still continuing to use the simplistic public versions of our quant strategies, believing the profits are magical compared to anything else they have used. Even though their gung-ho confidence in our methods is flattering, I am very sincere when I say that our publicly disclosed strategies should be starting points for further investigation on the part of readers -- not a combat-ready strategy index that we would provide to clients.

With that proviso, I think it is interesting, from a purely academic standpoint, to examine some extensions to Structural Arbitrage, a strategy we released in 2013. Our long time readers will remember that the idea behind Structural Arbitrage is that profits are possible by acting as a synthetic insurance company which sells expensive insurance in the volatility market, and then synthetically reinsures that market risk with long duration government bonds. The strategy is statistical in nature. On average, profits with the simple version of the strategy are possible, but not always. As we have seen, there are multiple ways to reinsure the risks we have underwritten. The simple public versions reviewed here have been created to explicate a specific part of the Structural Arbitrage phenomenon.

To review the original strategy's rules are:

  1. Buy XIV (NASDAQ:XIV) with 40% of the dollar value of the portfolio.
  2. Buy TMF (NYSEARCA:TMF) with 60% of the dollar value of the portfolio.
  3. Rebalance weekly to maintain the 40%/ 60% dollar value split between the positions.

Here are the strategy's results in a log scale:

(click to enlarge)Click to enlarge

What's interesting, is that it is also possible to sell mid-term volatility profitably as well. An extension of Structural Arbitrage is therefore obvious:

  1. Buy ZIV (NASDAQ:ZIV) with 60% of the dollar value of the portfolio.
  2. Buy TMF with 40% of the dollar value of the portfolio.
  3. Rebalance weekly to maintain the 60%/40% dollar value split between the positions.

The "reversal" of the 40/60 split in the original strategy to a 60/40 split in the extension is not my attempt to be mathematically cute or symmetrical. It is simply the most robust result while maintaining an extremely low correlation.

Here are the extension's results in a log scale:

(click to enlarge)Click to enlarge

In addition, another extension is rather obvious. We can sell both short-term and mid-term volatility simultaneously.

  1. Buy ZIV with 30% of the dollar value of the portfolio.
  2. Buy XIV with 20% of the dollar value of the portfolio.
  3. Buy TMF with 50% of the dollar value of the portfolio.
  4. Rebalance weekly to maintain the 30%/20%/50% dollar value split between the positions.

Here are the extension's results in a log scale:

(click to enlarge)Click to enlarge

I hope you've been enjoying the beach. The market tells a mathematical story for those with open ears.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.