Best Practice For Volatility Exposure

Jun.11.12 | About: iPath S&P (VXX)

There are several compelling reasons to trade and invest in volatility. When you want volatility exposure for diversification of an asset portfolio, where you strive to maintain a continuous volatility exposure over time; volatility products, swaps, or futures are probably not your best option. You should instead build and manage an options portfolio consisting of delta hedged equity options. In a delta hedged options portfolio, your result is derived from two sources: the mark-to-market result of the implied volatility of your options, and the trading result from your delta hedging (gamma trading).

The market in 2011 provides an interesting case for further understanding of the creation of value. In 2011, the S&P 500 index was at the same level at the end of the year as on the first trading day of the year. The year was interesting in the sense that it contained most market regimes; in the first half, realized volatility was low, in the 6-13 range, while the second half of the year experienced high volatility peaking at over 40. We had a nice and rising trend, followed by a range bound market ending in a 20 percent drop and finally a volatile rebound. Maybe the most interesting fact is that almost no single group of hedge fund strategies made money that year. The hedge funds performed poorly in absolute terms and compared to most sensible benchmarks. A well implemented volatility portfolio would have separated your fund from the crowd.

What then separates the returns from volatility exposure gained from common volatility products and the returns from an options portfolio hedged against market directional exposure?

In this backtesting, a simple delta hedged options portfolio (NYSEARCA:DVP) is compared with a volatility ETN as an alternative for volatility investing. For investors that wish to invest in volatility, the main alternative often is volatility ETF's that strive to track the VIX index. As you probably know, the VIX index in itself is not investable. VXX is a major volatility ETN that invests in VIX futures. VXX's performance is representative for the performance of Volatility ETN's/ETF's in general, as well as for managing your own portfolio of VIX futures. As seen in the chart, there is a significant cost of carry inherent in this product in most market regimes. The VIX index itself (that you can not invest in) have a high negative correlation to the stock market and reacts dramatically at market uncertainty. However, when uncertainty falls, the VIX index drops back, and would, if you could invest in it, provide little more than a way of raising your Sharpe ratio and protect against large drawdowns in your capital.

The delta hedged options portfolio, however, will protect you from drawdowns, raise your Sharpe ratio, and provide an alpha-source as the profits you made on the gamma trading component in a volatile market not is subject to the mean reversion of volatility itself.

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As seen in the chart, a stock portfolio (here, the SPX index) that is diversified with a delta hedged index options portfolio (DVP) performs on par with a pure stock portfolio in a non trending market. In a sharp low-volatility uptrend, the portfolio lags a little bit, but in a market setback and a high volatility environment it will outperform significantly. The portfolio that is diversified with a volatility ETN that tries to track the VIX index underperforms in every market regime, but when the market falls under high volatility, and even then it underperforms the portfolio diversified with a delta hedged options portfolio. As seen in the chart, the portfolio with the volatility ETN have a significant cost of carry that affects the portfolio severely in all regimes but an outright crash.

The delta hedged options portfolio is clearly an excellent diversifier of your portfolio in all market regimes. The performance will be even better if an option portfolio consisting of cheaper implied volatility is chosen (single stock options rather than index options) and is delta hedged with more sophistication than merely once a day, as in this example.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.