Market volatility is rapidly recovering from April’s lows. On April 20th the VIX (the Volatility Index) was 15.7. Yesterday’s price was at 31, after reaching a maximum of 40 on May 7th. This environment has created big problems on selling-volatility strategies, which were best performing among CTAs during 2009 and the first months of this year.
Short volatility strategies are able to provide stable results in nearly all market conditions, except in very particular circumstances, in which they may exhibit big losses. Usually these strategies have a track of 90% positive months, but in a negative month they may lose the profits of one year or more, depending on leverage. In statistical terms, this behavior is known as “negative skewness”. There are many trading techniques that may lead to such results: selling options, usually but now always out-of-the-money; using synthetic products like over-the-counter swaps betting on very rare market conditions not happening (like the Dow losing 10% in one single day). There are also some linear (i.e. made through futures or forex) strategies that may have the same results: they are the so called Martingales, i.e. high frequency systematic strategies which double the bet every time they lose money.
Each of the above mentioned strategies typically exhibit a saw tooth pattern with very stable returns until they make a big loss.
When we are talking about trend following strategies, the story is completely different. These strategies usually “buy high” and “sell low”: they try to follow a trend which has already started. They usually suffer in lateral market environments. But when a trend starts, history shows that the probability to persist is higher than to revert. Clearly these strategies have the problem of detecting the trend, but once the trend is started, they will stay in, mostly without exiting before the trend is over.
The current market environment is very interesting, because many trends are in place: the EUR weakness, the government bond strength, the gold rally to mention a few.
Academic studies show that trend following strategies exhibit a return pattern which is similar to a long straddle, with big profits in extreme market conditions.
Maybe the time is right for looking for such managers…
Disclosure: "No positions"