It should be noted that holding a static long volatility position over your investment career can be very expensive. While a small buy and hold volatility position will actually improve the risk adjusted returns of a stock/bond portfolio, it will come only by sacrificing absolute returns. Some investors may be okay with this, but most do not want to forgo potential upside should the Bull Market return. The self directed crowd often feel as if they need to play “hot potato” with these Vix related ETPs to minimize cost and buy/sell on shorter time-frames attempting to time the market. So who is right? Well they both are…

With a smart plan you can minimize the cost of holding a percentage of your portfolio in volatility. In fact, the good people over at Barclays Capital have put together one such plan. They call it the VEQTOR strategy and you can replicate it on your own or pay a fee to Barclays via the VQT ETP . Essentially, Barclays created a simple set of dynamic allocation rules. You can read more about this from an excellent post on SurlyTrader’s blog. The core dynamics to the VEQTOR strategy can be distilled into the following; VQT holds progressively higher volatility exposure when Implied Volatility is in an uptrend and as SPX  Historical Volatility increases and vis versa. This strategy certainly seems like it will be a winner in the long run, but from our research we see it has an Achilles’ Heal. It is essentially a trend following system and it will do well in very strong down trends (high volatility environments) and sustained uptrends (low volatility environments). However, when we have “confused” market action in between those two scenarios, like has been experienced since mid march, the added volatility exposure will likely erode returns as you can see in the image below.

At our sponsor firm we also advocate a dynamic allocation strategy, but in addition we also hold different types of volatility to reduce cost and prevent loss of capital while the market is trendless. Read more about our VHP product or check out its performance.

• Volatility 101 - What Is Volatility?
• Volatility 101 – Volatility Math Simplified Part I - Part II
• Volatility 101 - Fat Tails and Kurtosis
• Volatility 101 - Time and Uncertainty
• Volatility 101 – Types of Volatility: Realized | Implied

Do you own a stock, bond, or derivative? Did you ever wonder what active traders, professionals and market makers are expecting to happen to your holdings? Well you would know the answer if you tracked live Implied Volatility data!

What is Implied Volatility… The Short Answer

IV, as it is typically abbreviated, is the future Realized Volatility that option traders are pricing or implying into their contracts. Although you may not be an options trader, this concept still applies to your holdings and is not difficult to understand:

An option, at its simplest level, is a contractual agreement between two parties contingent on a future outcome. In this manner, the buyer of an option pays a premium to the seller, which is decided by the market forces of supply and demand. This purchase now entitles the owner of the option “rights” to cash or liquid assets if the necessary “event or events” occur in the desired time (yes, these contracts are normally only valid for a period of time). An insurance policy is the most common way that people participate in an options market. The purchaser of a policy/option pays a premium each month and if the necessary event occurs in that time period the option owner can exercise their rights. The event might be a car accident if car insurance, death if life insurance, or flood if flood insurance.

- Excerpt from FunctionalVolatility.com options article

Just like the insurance company, option traders are in the business of buying and selling these contracts for a profit. In some instances, traders are selling options because they think they are being over paid, at other times investors are purchasing these contracts because they need protection/insurance (many times fully accepting that they are overpriced). So how do they “price” these contracts?

What is Implied Volatility… The Real Answer

In a 1973 paper, “The Pricing of Options and Corporate Liabilities”, the now famous Fischer Black and Myron Scholes first articulated the beginnings of what is now termed the Black-Scholes Model. It essentially showed that all options have only one true price or fair value. They treated it similiar to a roulette table at a casino where a buyer (seller) purchases (sells) a known probability… for both parties to break-even in the long run only one true price exists. Unfortunately, unlike the casino, the market doesn’t have defined odds; however, if you extract the amount of money traders are paying for defined payouts you can then reverse calculate the odds they think they have. Suddenly we have a volatility number that active traders, professional hedgers and market makers expect in the future… and we call this Implied Volatility.

Using Implied Volatility

IV does a great job at telling you when to do your due diligence and when to put those time resources elsewhere. While IV is typically most valuable to options traders, it can also give the underlying investors/traders a head-nod into what might be on the horizon. For example, if IV30 (Implied Volatlity for the next 30 days forward) is 100% but typical HV30 (Historical/Realized Volatility over the past 30 days) is 50% than there is a reason for that difference. The options market is pricing in a major move (double the historical norm)! This could mean a substantial pricing event is coming and expectations might be all over the map. Let us assume it is an earnings announcement in 10 days. The “expensive” IV30 could be a result from a really smart (or dumb) Hedge Fund that is expecting a big miss or beat of the estimate. They could be buying or selling option contracts en-mass on speculation or heding; skewing the pricing (and therefor the IV) in the short-term (for example).

Unfortunately, IV is not the Holy Grail for investing. It won’t tell you what to look for specifically, or the exact reason IV may be elevated (or depressed). Knowing you might be exposed to a risk you are unaware of and should be looking for something is really the value. Often you will get unimportant information that is passed off as big news. If the options market doesn’t seem to care (and you should always assume it knows everything, at all times) don’t overly weight it. In general, unless you just had a cocktail with the CEO (wink wink), this information is already known and priced-in or simply not important to short-run pricing. For those just starting to factor IV analysis into their research and trading decisions, three common reasons for elevated IV are upcoming earnings, pending court-decisions, and anticipated changes in management or leadership.

Implied Volatility’s Relationship with Historical Volatility

You can get free IV data from www.ivolatility.com. In the above chart, take notice of how traders expectations of volatility tracks realized volatility. While they are both highly correlated, IV tends to overshoot and undershoot (with the former being the “normal” state of the options market). In other words, IV has a higher Volatility of Volatility than HV.

• $VIN (Near Term options expiring soon)
• $VIF (Far Term options expiring in the  future).

Speculators and hedgers trying to get as much notional exposure for the smallest capital outlay typically use the nearest term options. These are the aggressive orders coming in and out of the market. Some may not be aware that it is not necessarily large order size that moves the market, but aggressive orders that don’t care about price improvement (aggressive large tickets would be an obvious extreme form of this). Because of this, we feel the $VIN gives us a better snapshot of the how short term traders/hedgers are thinking and reacting. Today shows a large departure in behavior for $VIN and $VIF. If you had the “Vix Trade” on… this is probably a safe place to take money off the table depending on your goals and risk apatite. The short term mean reversion has taken place!

Some people get a little carried away with what method they use as a trigger, we are firm believers in keeping a trade setup simple. It does not matter what Vix method you choose as they will all trigger roughly the same signals. We also believe the only reason this setup still works is because of how it can feel like the wrong position to take at the time. Because the Vix signal is based off of hedging activity, you will always be taking risk when most are avoiding it. We also suspect that most would-be-Vix-traders get burned or bored by this set up, which keeps the markets’ memory low. Here are some reasons traders fail at this trade:

• Leverage: Go Big or Go Home!
• You may make a killing using excessive leverage, but we can tell you how your last career trade will go… VIX FAIL!
• The Vix can always go higher – use risk-management!
• Assuming it is infallible. This setup may work many many times, but never assume it will work this time.

• Expectations: Traders expect too much from this trade.
• The edge is very short term in nature (sometimes less than a day) – don’t turn it into something it is not… if you stay in it too long, you are now a trend follower not a counter trend trader.
• It is also not a home run set up either (.5-2% typically on Major Indexes) – don’t over leverage yourself to make up for that.

• Boredom: It triggers infrequently, only a few times a year at best.
• Only take real set ups! Find something else to do with your time…like reading blogs about volatility…

• Ignorance: They know just enough to be dangerous
• The Vix doesn’t care about stop losses – its playing an “area” and a sentiment, not a price point → find a better way to manage risk.
• Scaling in small to prevent from getting hurt but also never make any money → find a better way to manage risk.
• They try to do the trade directly on Vix ETPs or Vix Options → These are far removed from the Vix and may add risk that is unknown to the trader.
• The best ways to take this trade (In our opinion) is not a straight buy or sell. Choose a basket of positions that will respond best to each signal and use options to build more edges/manage risk.
• Create market filter rules that will help to determine exposure to each signal. Ours are all based on volatility (Green, Yellow, Red zones).

Yes, we understand you are absolutely terrified of the concept of shorting a naked put options. Why? Because your broker honestly doesn’t understand them. But with a little understanding you should embrace them.

Deconstructing the Naked Put Option

First off, shorting a put is a bullish position that will mimic a long position. Second, Naked means that the position is “uncovered” or without protection. If you were short a naked call this would mean an infinite loss potential. This negative stigma has leached its way into naked puts causing confusion. Although a naked put is technically an “uncovered” trade, it is the synthetic equivalent of a Covered Call (hard to believe?). Who knew the scariest trade your broker ever heard of is actually a plain vanilla covered call. As a matter of fact, because these trades are so unloved they tend to have slightly more attractive premiums to sell than covered calls. When shorting Naked Put Options (as well as covered calls) on the SPX you assume less risk than buying the good old SP500 (just don’t over leverage your position else that will defeat the purpose). If the SP500 were to fall to zero, the person who sold the option would still have the premium they collected. Moreover, you will be selling these assets to Fearful “late-to-the-party” hedgers or greedy “dumb” speculators (One of our favorite things to do).

In the chart below, you will see how naked puts can outperform the SP500 during these key risk flare ups. So if you are like us and want to either swing trade around a bottom or rotate your equity exposure to increase return or cut risk… give Naked Puts a second look ($PUT)! Learn more about our VRP-DA investment Model which uses Naked Puts to generate monthly income.

Short answer: You must put capital to work in fundamentally different investments.

Generally, this will mean separate asset classes (eg. Stocks, Bonds, Precious Metals, Real Estate, Volatility, etc). The goal is to be invested in opportunities that will behave in a unique way most of the time in most situations. For this to be the case, investments have to be different at a fundamental level. If we take stocks and bonds, for example, we see underlying and structural reasons to explain their price movement (frequently in opposite directions on any given day). Because they have very different capital structures, they each result in differing risk/reward profiles. Thus, as investors’ risk appetites change with the mood of the market, money flows into some assets and out of the others.

Typically, “asset allocators” seek to invest in LOW or INVERSE correlation market choices, such as stocks and bonds. Our firm falls in that category but we want to avoid overcrowding into positively/highly correlated choices because if our investments always move together in near lock step, then we are essentially exposed to the same or very similar risks referred to by a different name. Did you read that last sentence over? Do you understand it?

These positive correlations are typically found when investing within an asset group. Stocks, for example, almost all have positive correlations to each other, some more so than others, and that correlation increases under market stress. This means investing in 10 different stocks or even 100 different stocks will not diversify you against market swings when you need it most (the same goes for accumulating within any asset class)!

Think about it: Recall any significant market sell-off. What did the S&P, DOW, Nasdaq, and others do? They dropped in value and no amount of diversification within different stocks would have prevented that.

Juxtaposition, inversely correlated assets will move in opposite directions. For example, when we look at stocks and the Volatility Hedging Program (VHP) as a pair, we see they exhibit a strong inverse correlation. In fact, the inverse correlation and beta of the moves are most reliable and magnified during times of market stress. This means they do a great job of hedging the other’s risks. One could also note from the graphic below, that because VHP has such great convexity (explodes up in value quickly relative to any drop in value) you might only need a small percentage of your portfolio invested in it to protect a large percentage of your net worth.

VHP in Blue vs. SP500 in Red <Click to view interactive chart>

Another takeaway: when re-balancing this inversely correlated pair (generally after a market shock event or a sustained bull market) you are either allocating capital into equities when they are cheap with proceeds from your “hedge” or taking profits from elevated equities into an insurance policy that will pay off well when the market undergoes its next major sell-off. When you have a stable pair like this you will always invest into/near the bottom without suffering the mark-to-market hit of being all in equities. Market timing is suddenly now no longer necessary because your Profit & Loss will dictate when to move money into or out of stocks. Lastly, if the other segments of your portfolio are in LOW correlation choices, then you need even less insurance and will benefit even more from diversification and re-balancing!

To stay up-to-date about new product offerings, volatility presentations, or inquire about investing in any of our products/funds, please contact us.

• Volatility 101 - What Is Volatility?
• Volatility 101 – Volatility Math Simplified Part I - Part II
• Volatility 101 - Fat Tails and Kurtosis
• Volatility 101 - Time and Uncertainty
• Volatility 101 – Types of Volatility: Realized | Implied

As investors, we tend to obsess over the future. “What will my annual rate of return be? My risk? What year can I retire to my vineyard with a statue of myself in the Apiary?” (haha, made you click!) Well, most often the best hints for the future resides in the past. We have all heard the “past returns are no guarantee of future results” legal disclaimer, and while it is true, we are not concerned with guaranteeing results; only trying to make intelligent decisions.

When attempting to forecast future volatility and the risks of a particular stock or portfolio of assets, professionals often utilize Realized Volatility. Arguably the most commonly cited type of Volatility, it describes price action that has already occurred in the past. Because it is calculated from historical data it is often called Historical Volatility (HV) or Statistical Volatility. Realized Volatility = Historical Volatility.

Measuring Realized Volatility

When discussing realized volatility we need to decide what time frame of the past we want to measure. For example, common periods to look at are the previous 10, 20 and 30 day volatility. Most often a sliding window is used so that we can update and chart the metric daily (i.e. trailing 10 days). This is similar to how a moving average is calculated from a trailing period. As a general rule of thumb if you want to get a “feel” for volatility in the next 30 days you should use the respective 30 day look back period.

One should note, however, that volatility is very event sensitive. For example, if the market is waiting on a significant piece of news, realized volatility might be very low and then explode very high on and after the event. This can cause artifact data to skew your assumptions in the short run if you are unaware of them.  In general the longer the period you measure the more smoothed and structural/characteristic in nature the volatility; the shorter the look back period the more potential exists to see event driven and extreme volatilities. A good way to often tell if you are looking at event driven or an extreme volatility period (low or high) is to compare the ratio of a longer period volatility (HV30, HV90, HV252) to a shorter period (HV10, HV20). If there is a large spread between the two, it might be a good idea to find out why; Earnings coming up? Fed Meeting? Court decision etc.

For those who are more familiar with volatility, an advanced concept is often to normalize Historical Volatility. This might mean dropping extreme high and low readings from the look back period. This has the effect of smoothing out “artifact” and capturing a smoothed structural volatility that still captures that periods volatility environment. We have often used this approach when screening and pricing options to buy and sell as either income producers or for hedging. When this approach is used on a large basket of securities, as opposed to on individual stocks, it often works quite well in providing a more accurate future guess of volatility.

Using the Data for Good

Volatility’s most frequent function is to quantify risk. Thus we can take our realized volatility readings and use them to formulate a risk management plan. For example, let us assume we are investing in a stock with HV20 of 10% vs. a less volatile stock market index with HV20 of 5%. In that situation, we assume we will encounter more risk (approximately double) by investing in the stock vs the index. If you thought you had an edge to compensate for the extra risk, you may still need to lower the total amount of exposure to be more acceptable for your portfolio. Often professionals use the concept of Beta to measure this type of volatility risk. Beta is the amount a stock moves relative to the market as a whole (with 1.0 being a lock step move with the market). If the correlation of the stock and index was high then based off of realized volatility we would assume our position might have a beta close to 2.0, so how could we structure this trade to come more inline with the index. There are literally millions of ways, but here are a few common solutions;

• You could raise cash position/cut position size
• Hedge exposure:
• Investing in low correlation investments (low beta or negative beta stocks or low/negative correlated assets) that do not go against your original investment premise
• Buy insurance through options (only if not over priced)
• Sell insurance against your position through options (only if over priced)
• A combination of the above two (Collars/Married Put, ratio spreads, etc)
• Gain short exposure against your position using derivatives, contra-ETFs, or a basket of what you think will be under-performing stocks (your Anti-thesis portfolio)

• Volatility 101 - What Is Volatility?
• Volatility 101 – Volatility Math Simplified Part I - Part II
• Volatility 101 - Fat Tails and Kurtosis
• Volatility 101 - Time and Uncertainty
• Volatility 101 – Types of Volatility: Realized | Implied

The long term median volatility for the Dow Jones Industrial average over the past 100+ years is about 15%. We might have a general impression of what that means on a year over year basis; however, what does that actually translate to on a monthly, weekly or daily time interval?

Volatility has an interesting relationship with time because Volatility is proportional to the square root of time.  What does that mean for us? Well because Volatility is quoted as an annualized value, we can reverse the math to come up with a higher resolution (smaller) time-period. This allows us to understand how much the market is expected to move on any given day. Imagine how calming and potentially helpful that could be when placing hedges, stop losses, etc. There are a few “quick and dirty” ways to figure this out and Bill Luby over at VixandMore has done a great job discussing some of them. But first let’s make sure we set the stage so you don’t get lost in the calculation or methodology (we promise its not that bad).

Volatility’s Relationship with Time

To the right we see volatility represented by the Greek symbol Sigma (σ). Notice that it is in fact proportional to the percentage of the year (i.e. 6 months is 50% of the year) represented by “Delta t” (Δt). As we look at smaller time periods, we will be multiplying σ by ever smaller Δts which will yield smaller volatility numbers. This makes sense since we would expect less drastic movement in shorter time frames (1 day) than there would be in longer time frames (1 week).

How many days are in a year?

Before we can divide the year up into parts, we must first determine what it is as a whole. Is it 365 days? or just trading days? Because we are only concerned with price movement, it would seem logical to only count trading days. Moreover, a significant amount of empirical research supports such an approach. It has been found that in most markets, price fluctuations do not move more over weekends/holidays than on typical overnight sessions. If you wanted to be very accurate you could actually count the seconds of open trading time each year (no seriously, some analysts do this!), but for the granularity most investors are looking for, counting days will do just fine. In the United States market, we have on average 252 trading days in a trading year. So for clarification, 100% of a trading year = 252, not 365.

Common Time Frame Examples:

Below we have outlined several common periods that investors might want to better analyze. Each example assumes an annual volatility of 20%.

You can also look at any other time frame as well simply by finding what %  of the year they represent. For example:

• Daily = 1/252  or .004
• Weekly = 1/52 or .019 (also can be stated as 5/252)
• Monthly 1/12 0r .083 (21/252 gives same result)

There is are three important concepts to understand when calculating volatility. If you plan on adjusting your investment plan/behavior based off of volatility findings, you must make sure you understand them and don’t forget their principles. Once understood, investors can use this information to adjusting hedges, set stops, and adjust position sizing.

1. Volatility assumptions used to derive your answer might not be accurate going forward. (“Wait……What?”) Leave yourself a margin of error!
• If using past data to predict future data – the market might materially change in the future (“Ah….ok, right. I forgot about that for a moment….duh.”)
• If using an implied number like the VIX  - Option traders might have got it wrong
2. The expected Volatility number only represents a 1 standard deviation move (learn more Volatility 101 – Math Simplified Part I &II)
• 68% of the time you will have a move that is equal to or LESS than your expectation
• about 1/3 of the time you should expect a move that is GREATER than the answer you found (when everyone is in panic mode you should expect that to happen at least 1x a week)
3. Typically markets are NOT NORMALLY DISTRIBUTED (learn more Volatility 101 – Fat Tails, Kurtosis and Skew)
• the MAJORITY OF THE TIME markets move MUCH LESS than a normal distribution would expect
• the MINORITY OF THE TIME markets move MUCH MORE than a normal distribution would expect
• Makes sense right? Think about the market going on a bull run for weeks and weeks advancing 0.1% – 0.6% every day tirelessly. Then WHAM!, in the course of a few days its right back to where it started.

 ”The Rule of 16″

Although the math above is not at all complicated, it is often just enough to have a quick estimate of what to expect on any given day. Bill Luby over at VIXandMore Blog does a great job discussing this in several posts, of which this is our favorite.

“We cannot truly plan, because we do not understand the future–but this is not necessarily bad news. We could plan while bearing in mind such limitations. It just takes guts.” – Nassim Taleb The Black Swan

The above quote is from a popular book written by Nassim Taleb, which broadly discusses our human limitations when coping and comprehending risk. The term Black Swan is in reference to a species of dark colored swan discovered at a time when all swan species were “known” to be white. It is a beautiful metaphor for the  the impossible becoming possible.

The risks in the market can be summed up into two categories; Foreseeable Risks and Unforeseeable Risks. The problem with the later is obvious; even Mr. Taleb says not to spend too much time trying to predict them – you can’t. And if you really think you can, you have become the black swan. The more disturbing reality is that because of our thought process many Foreseeable Risks tend to blindside us anyway. The reason is explained by normalcy bias – a human trait that causes us to underestimate both the possibility of a disaster and its potential effects.

“But this time it’s different!”

As a species, we weight personal experiences more heavily than the written/oral experiences of others. We habitually project our impression of the future based off of our realized reality from the past. We simply don’t live long enough to “remember” outlier events and, conversely, we are not innately wired to truly “learn” from past generations about what will inevitably happen to us. These same dynamics fool us into believing AAA ratings from financial companies or assuming United States Debt is risk-free (if you blindly believe it is, you are suffering from a textbook case of normalcy bias – risk-free cannot exist).

To look at investments in this manner can be paralyzing, but you should take comfort that there are ways to manage such risks. Always remain educated and informed with a healthy dose of skepticism, as this will keep foreseeable risks from blindsiding you. Lastly, spread your investment risks broadly across uncorrelated assets. This means using a diverse portfolio and possibly owning the Black Swan event (one way of doing this is by investing in “fear” via Disaster Funds similar to our very own VHP). Following this advice doesn’t mean you will consistently make solid returns, that would be too omniscient of you; however, every step you take to further diversify yourself will increase your odds of financial survival. Why put your capital at risk and waste time and effort only to leave your portfolio open to sudden unrecoverable losses?

Just being aware of this concept should already change the way you think and participate in the markets. To learn more about market volatility and how it affects your portfolio risk, visit our Volatility 101 Series and pay particular attention to the concepts covered in the post on Fat Tails, Kurtosis and Skew.