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When Is The Best Time To Start Trading A Volatility Strategy?

|Includes: ProShares Short VIX Short-Term Futures ETF (SVXY), UVXY, VXX, XIV

One question we often get asked is: When is the best time to start trading a volatility strategy (if I'm not already invested)?

That's a fair question.

Our best answer: volatility strategies, at least the strategies we trade at VIX Strategies, are meant to be long-term strategies traded over a long period of time. Our goal is to capture the long-term statistical edge provided by the Roll-Yield, Volatility Risk Premium, and Mean-Reversion. While the date you get started will certainly impact your short-term results, over the long-term, however, your start date should be a minor factor. This is especially true if you invest the same amount of money into the strategy over a regular time interval (investing an additional $10k at the start of each year, for example).

However, most people don't like our best answer. Most people want a more "concrete" answer that tells them exactly when to get started.

Ok, we'll play along.

Our "concrete" answer: the best time to get started is during a drawdown. The simple 'buy low sell high' axiom. Notice we said "best" and "simple", but not "easy". Starting during a drawdown is excruciating, and anything but easy. How large will the drawdown be? How long will it last? Does the strategy even still work? All these questions will pop into your head. The best buy/sell points for any trading strategy are rarely at comfortable spots, and if you want to try and "time" your start, rather than follow our best answer above, you will need to be comfortable being uncomfortable.

Luckily, we have a pretty neat and simple method for you to accomplish this that actually pays you to start during a drawdown.

Before we move on, however, there is one thing you'll need to understand about our core volatility strategy, Roll-Yield + VRP, and volatility ETNs/ETFs: we spend about 80% of our time long XIV, a short volatility ETN. XIV does not have options. A similar instrument, SVXY, is a short volatility ETF that does have options. Because our Roll-Yield + VRP strategy is usually long XIV, our examples below will use options on SVXY to time long entries on SVXY (similar to long positions of XIV) during a drawdown.

Ok, back to the good stuff.

How to time starting a volatility strategy during a drawdown

1) Wait for a relatively large drawdown in SVXY

  • "Relatively large" is where your judgement comes into play. You might consider multiple down days, a certain % drop, etc.

2) Sell Put options on SVXY at a strike price below the current market price

  • Sell 1 put contact for every 100 shares of SVXY that you would like to get long.
  • For the strike price, choose a price at which you are comfortable getting long SVXY.

3) Let the option expire

  • If SVXY is above the strike price at expiration, you collect 100% of the option premium. Hooray! You just got paid to wait for a lower price that was never reached. You can sell more options (hoping to get assigned) or walk away and wait for the next drawdown.
  • If SVXY is below the strike price at expiration, you collect 100% of the option premium AND are now long SVXY during a drawdown. Hooray! You got paid to start a volatility strategy during a drawdown - the "concrete" answer for when best to get started.

To be clear, with this option assignment method, you hope to actually get assigned on your short option at expiration (you're effectively getting paid to get long at a lower price than the current price - or getting paid to 'buy low sell high' during a drawdown). If you don't get assigned, however, you're still happy earning the premium from selling the options.

Let's walk through some real-world examples, with actual option pricing:

Example: 1

Date: 6/24/2016

Event: Day after Brexit Vote

SVXY Drawdown: 35% from recent high on 6/7/2016

SVXY Price: $43.13

Position: Sell 1 of the 7/1 38 strike puts for $2

Time of Entry: 3:55pm ET

SVXY Price Graph 6/24/2016

Short Option Payoff Profile

Economics: You're effectively committing yourself to getting long SVXY at $36 ($38 strike - $2 premium), or 16.5% lower than the current price, and nearly 46% lower than the recent high, if SVXY trades below $38 at expiration. To look at it another way, you're earning a 50% yield to potentially get long SVXY at $38 if SVXY trades below $38 at expiration.

SVXY Price Graph 7/1/2016

On 7/1/2016, SVXY traded at 50.59. Your short option expired worthless. You earned 50% on your short option position. Hooray! In this example, you did not end up getting assigned (you did not end up getting long SVXY), but you're still probably pretty happy to earn the entire option premium.

Example: 2

Date: 10/28/2016

Event: Upcoming US Presidential Election

SVXY Drawdown: 10% from recent high on 10/24/2016

SVXY Price: $73.45

Position: Sell 1 of the 11/4 68 strike puts for $0.85

Time of Entry: 3:55pm ET

SVXY Price Graph 10/28/2016

Short Option Payoff Profile

Economics: You're effectively committing yourself to getting long SVXY at $67.15 ($68 strike - $0.85 premium), or 8.6% lower than the current price, and nearly 17% lower than the recent high, if SVXY trades below $68 at expiration. To look at it another way, you're earning a 9% yield to potentially get long SVXY at $68 if SVXY trades below $68 at expiration.

SVXY Price Graph 11/4/2016

On 11/4/2016, SVXY traded at 64.35. Your short option expired in the money, so you got assigned 100 shares of SVXY for every put option you sold. You are now effectively long SVXY at 67.15. Hooray! You started a volatility strategy during a drawdown - the "concrete" answer of the best time to get started, and got paid $0.85/share to do so. Let's see what happened to your long SVXY position a few weeks later.

SVXY Price Graph 11/18/2016

Just 14 days after getting assigned on your short option position and effectively getting long SVXY at $67.15, SVXY is trading at 81.52 - you're up 21.40% and are off to a great start on your (hopefully) long-term commitment to your volatility strategy.

Of course, not every situation will be this "clean" and you may face addition drawdown after getting assigned on your short options. You should already be prepared for this before starting any volatility strategy, however.

Summary of Option Assignment Method

1) potentially start trading a volatility strategy at the most opportune time - during a drawdown

2) get paid to buy at a lower price than the current price

3) still make money if the underlying (SVXY in our examples) stays flat or increases

4) you are "forced" to take the position (if you let the option expire in the money), preventing your emotions from getting in the way

5) know exactly what your effective price will be

Implementation

While we believe this is a great method, one of the main problems of trying to time the start of a volatility strategy is that you may end up waiting a long time for a drawdown to occur. During this time, you are likely leaving money on the table by sitting on the sidelines (you give yourself less time to earn the long-term statistical edge). We believe the best way around this is to start trading with a "core position" (do not wait for a drawdown on this position) and simply add to your core position during drawdowns using the option assignment method outlined above. This way you give yourself maximum time to earn the long-term edge, while also investing more money at favorable prices during drawdowns (or getting paid to wait if not assigned).

Disclosure: I am/we are long XIV.