Biggest volatility investing strategy mistakes

We think you’ll agree there are a million viewpoints on where broad market volatility is going, and which volatility investing strategy is best. Too many times we see individual, a.k.a. retail, investors shouting from the rooftops that now is the time to get long vol, it’s bottoming out, it’s about to blow, load up now while there’s time, etc. They are generally referring to the “long volatility” ETN products like VXX, or even the leveraged products like UVXY.
At Post6, that is NOT our strategy. In fact, we strongly disagree. In our seasoned opinion, owning (a.k.a. “long”) volatility in this manner is not a medium to long-term solution for a volatility investing strategy for retail investors.

Trying to pick VIX “spikes” is a volatility investing strategy best left to the pros

In this post we will expand on the two base camps that exist in this corner of the broader market, which is generally the realm of options traders. But, thanks to the introduction of volatility ETNs, the playing field has been leveled in a sense. Don’t worry, we’ll explain how later.
First, let us offer some insight into the options trading world that may not be apparent.  Just like there are stock owners and stock short sellers, there are those who like to own volatility, “long vol,” and those who like to sell volatility, “short vol.”  We briefly introduce this valuable notion in our book, “Volatility Trading Demystified for Retail Investors,” available here on our site or at Amazon.

Why is understanding this notion valuable to you? Because it can help you filter through the noise.

Two distinct camps: Long Vol, Short Vol

First let’s make sure we are crystal clear on some terminology: “vol” in this scenario is “volatility,” not “volume.” If we are ever talking about volume as opposed to volatility, we’ll be sure to make it clear.
Obviously, Long Vol is owning broad-market short-term volatility as an asset. For the majority of retail investors, that will consist of a long position in the VXX ETN or a similar product.
Conversely, Short Vol is selling broad market short-term volatility as an asset. For the majority of retail investors, that will consist of a long position in the XIV ETN or a similar product. This is what makes XIV unique and causes it to possess some very attractive characteristics for the retail volatility investor.
Let’s jump back to the “Long Vol” investor. For this investor, the headwinds are strong from the entry-point most of the time. That means the entry timing is going to have to be fairly precise (i.e. just prior to a meaningful volatility spike) to overcome the initial headwinds, or you’re going to need to be willing to trade fairly frequently.
To cement this concept and truly understand the strength of the headwinds, knowledge of the following is required:

  • The VIX index reading
  • VIX futures contracts
  • VIX futures term structure
  • VIX futures risk premium
  • VIX-based ETNs

To gain this understanding, our short book, “Volatility Trading Demystified for Retail Investors,” is a great resource and is available here on our site or at Amazon.  Then, once you’re solid on these concepts, you will want to subscribe to our strategy, VIPER. It is designed specifically with the retail investor in mind and seeks to maximize an investment in volatility as an asset class.
As if that’s not enough, we will let you in on another truth:  trading long vol profitably is extremely complex for retail investors.

To address this complexity, we present the top 5 reasons why trying to play long vol as a profitable investment strategy is much harder than the average retail investor thinks:

5. A Long Vol position must be hedged for profitability.

How do the pros combat the aforementioned headwinds?  They hedge the position, and they hedge it effectively.   That’s right, unless the entry point is timed PERFECTLY (a.k.a. luckily),  the long volatility position must be hedged effectively while waiting for the big volatility spike. The complexity arrives from the construction of the position that is required to enable the hedging. This leads to our next point, which is unfortunately going to require even more education for most of you reading this.

4. A solid understanding of options trading is required.

Before we lay out this hypothetical scenario, we acknowledge that this is by no means the only way to obtain a long volatility investing position and then to commence in hedging that position profitably. This represents one example. Very well, onward.
An effective way to engage in hedging would be to obtain option gamma in the volatility asset. Option gamma will allow for the position to be hedged in a profitable manner as the underlying asset moves with market conditions. The most straightforward method of doing this would be to purchase an at-the-money straddle in VXX options at a roughly 30-60 day expiration time window. Are you confused yet?

3. Good options pricing is required to ensure the long options position is obtained as cheaply as possible.

Most reputable brokerage firms have fairly accurate options pricing, but your particular environment may need to be configured so that the software is showing you option contract characteristics like implied volatility and optimally a base level theoretical value of those same contracts. At this point it’s essential to know if you’re paying a fair, and optimally, a cheap price relative to recent market conditions and VIX levels for the straddle position. This position will require you to simultaneously purchase a call contract and a put contract of identical strike price and expiration. This will obtain a sufficient quantity of the option gamma required to conduct the hedging. Suffice it to say that after reading to this point, if you do not have much of a grasp of what we’re describing, you should thoroughly familiarize yourself with the basics of options and options trading before attempting to engage in this.

2. Either “babysit” the position into perpetuity during market hours, or set hedging “intervals.”

Remember, the path to profitability in a long volatility strategy requires effective hedging. To do that, you’ll be buying and selling the nearest-term VIX futures contract. As the futures contract fluctuates in price it will be influencing your options straddle position. The option gamma you obtained when purchasing the straddle will be generating a unit of immediate risk management, which is the option “greek”, “deltas.” These “deltas” are a very handy reading, as they basically dictate the quantity of VIX futures bought and sold to hedge the position. The most automated approach at this point would be to find the most profitable hedging “interval” (the rate at which one would buy underlying futures when the VIX slips, and sell them as the VIX rises) that corresponds with the deltas the straddle position will be generating.  No pencil and paper required these days.  Computers will crank it out and you can manage that yourself or possibly obtain it from a research firm. Orders to buy and sell can be input for execution as the prices stipulated become current in the market, but even that level of automation does not detract much from the overall attention required to successfully manage a position of this nature.

Don’t forget the options portion of this position requires careful management at certain time intervals.  In our example, the options straddle position will need to be closed out and reinitiated at further out expiration dates, or rolled out as it approaches its own expiration.  The concept of rolling this hypothetical position is beyond the scope here, but is definitely a complex topic for the retail investor.

1. Short-term capital gains taxes, a futures trading account, position management and adjustment all while waiting for “your ship to come in.”

Hedging this long gamma position may very well be profitable, even handsomely so.  As long as most, if not all of the puzzle pieces snap together smoothly: it is well executed at initiation, managed well post initiation, and hedged in accordance with a historically profitable hedging interval .  For retail individual investors, the odds of this volatility trading strategy coming together well are stacked against you. It also requires exactly what a brokerage wants you to do: trade frequently. This just generates fees for the brokerage.

To summarize a solid “long vol” position:  if it is executed well and subsequently managed well, it should be well positioned for a big volatility spike and should reap big gains in that move. The downside is the five points discussed above.

At Post6 we prefer the “short vol” camp. The five points above are virtually eliminated.  There is no options trading involved. Our preferred instrument, the XIV ETN encapsulates many of the attractive properties of being a volatility seller, with a fraction of the risk profile usually associated.

The trick in our volatility investing strategy is to minimize adverse effects and weather the storms.

That’s where we come in. The volatility marketplace has many success stories from the short volatility camp, and of course, some not-so-successful.  We are seasoned volatility investors and we provide “big picture” discipline to VIPER. The potentially dramatic missteps are identified and mitigated as much as possible. The strategy is built around this discipline, and geared specifically to the retail investor. Most notably by our strict adherence to the T+3 rule when exiting a position.  Sure, there are drawdowns, they cannot be avoided.  But with our seasoned approach, the results tell the story.

Finally, a volatility investing strategy for the little guy, which minimizes trading and takes advantage of all the XIV ETN offers.