This post apparently was deleted, so I'm republishing it here...
In an episode of 'Friends', after discovering that his apartment had been robbed, Chandler was asked what his insurance company said; to which he replied... "they said, 'YOU DON'T HAVE INSURANCE HERE, SO STOP CALLING US!'"
However trite the allegory, it illustrates the need we all have to be protected.
At one point or another, everyone's heard that the best way to invest is to buy and hold. The idea being that the longer an investor's time horizon, the less exposed he or she is to random events or deviations from an expected return. While this approach seems simple enough, it is (more often than not) difficult for investors to simply turn a blind eye to the drastic impacts short term market volatility can have on their retirement, college and general savings. Possibly more difficult is for an endowment, foundation or pension to meet immediate obligations when years worth of contributions and returns are wiped out in the relative space of the blink of an eye.
THEORY vs REALITY; DEVIANCE vs FEAR
Volatility is formally defined as a 'measure of dispersion of returns for a security or market index.' Besides being incredibly boring, the biggest problem with this description is that it doesn't distinguish between positive and negative deviations... and why should it? Nobody's afraid of positive deviations... positive deviations, like finding a twenty dollar bill in your coat pocket, are pretty awesome.
However, like most things, volatility acts very differently IRL (that's 'In Real Life' for all non millennials). In fact, most millennials may be acutely unaware of what real volatility looks like because they were still in school the last time American equity markets experienced any. In real life, volatility is fear. Fear that swift and unforeseen market movements will erase hard earned returns and principal.
BUY UMBRELLAS ON SUNNY DAYS
If you've ever been walking around Manhattan when a random rain storm hits, you know just how fast the price of those little pocket sized umbrellas can skyrocket... only for them to break 3 days later and be rendered useless.
It's axiomatic that investment protection needs to be in place before the storm... because when things go wrong, the only thing moving faster than the red numbers at the bottom of your screen is the price being charged to protect what's left in your book.
I'm going to evaluate three types of volatility hedges designed to protect against systemic corrections. The three methods are: volatility ETFs, cash securities and option overlays. Each method will be considered on the merits of effectiveness and manageability.
VOLATILITY ETFs
Exchange Traded Funds tied to volatility are one way of buying protection for your portfolio and they are available with a myriad of risk characteristics ranging from the mild-mannered medium term/non-levered (VXZ) to the short-term/ultra levered, roid raging, rip your face off (UVXY).
In terms of effectiveness, volatility ETFs are very good at reacting to changes perceived market risk. Their prices are tied to the VIX which is a futures contract based on the implied volatility in S&P 500 options. When markets start to get uneasy and traders are taking liquidity out of S&P puts, the VIX (and by extension) volatility ETFs will respond rapidly and exponentially.
This all sounds great but there are major downsides to volatility ETFs. In terms of manageability, the only thing they have going for them is their liquidity... these things get traded a ton and the spreads are congruently thin. The downside, however, lies in timing. Since the VIX is priced off of futures contracts, volatility ETFs are subject to a phenomenon known as contango. Contango occurs because of the time decay in the futures contract... just like an option, the extrinsic premium associated with a derivative erodes as it nears expiration unless the underlying asset price exceeds the strike and premium charged at the time of purchase. When the VIX rolls over to the next monthly contract, it basically sells the old contract low and buys the new contract high (unless there has been an increase in implied volatility).
To give some color on how erosive contango can be, consider the UVXY (the one jacked up on steroids ready to rip your face off)... as of last Friday's close, the price was $29.11. Using this as a baseline, the price of this ETF 6 months ago would have been over $125. Basically, they just keep doing reverse splits on this thing every time it gets close to being a penny stock. The last reverse split sent the price from less than $10 to over $40... that was literally just a few weeks ago.
Here's what contango looks like:
To make these ETFs work, you have to time your executions perfectly... from buying just before implied volatility picks up and selling just as sentiment is bottoming out. Needless to say, this is difficult at best.
Basically, these things are like a tattoo you got in college. It seemed like a good idea at the time but it's aged badly, you're ashamed to let anyone know you've still got it and it's going to be expensive to get rid of.
CASH PROTECTION
The saying goes that 'cash is king.' Whoever said this wasn't speaking in the context of using cash securities to hedge market volatility.
Before I get into it, I want to clarify that I'm not talking about relative value or portable alpha types of trading where indices are shorted in direct relation to a basket of underlying securities (presumably with no basis risk 'wink, wink' (I don't do emojis)).
Shorting a cash index ETF, like the SPY, to hedge a portfolio of securities isn't as bad as an idea as it sounds... it is, in fact, slightly less worse than it sounds.
In almost a direct contrast to using volatility ETFs, shorting cash instruments is largely ineffective because of the absence of leverage. Leverage is everything in asset protection. Using an option with a leverage factor of 10x, I can limit a position to an eleven hundred dollar loss using only one hundred dollars. This is why I go to great depths to detail leverage in the option overlays on the swing trades I've posted on this blog. Short index trades designed to hedge a basket of long securities are typically held in relative proportion to other components of the portfolio. When markets turn down, they are assured of providing relief but only in direct relation to their size within the book.
The benefit to cash protection is solely in its manageability. Losses on the short can typically be easily offset by gains in the portfolio's long holdings. Liquidity of index ETFs also tends to be excellent. Because they're cash instruments and not related to a derivative, they don't lose value with time... investors can hold short cash hedges basically as long as they want. The lack of overall protection, however, renders this type of hedge (manageable as it may be) largely ineffective.
OPTION OVERLAYS; OF CATALYSTS AND CRISES
Finally, there's the option overlay strategy. Unlike the previous two means of gaining volatility protection, options are the both effective and highly manageable... assuming you know what you're doing.
Mostly every successful options trader will only buy an option in the event of some form of catalyst... something that will move the price of the underlying asset sufficiently far and sufficiently fast enough for him or her to realize a substantial profit. As I mentioned before, the key to protection is leverage and options are all about using leverage to achieve outsized returns.
Here's a chart that I've used before that shows the relationship of option leverage to time to expiration on a September SPY $206 strike put (SPY closed Friday directly at $208):
As you can see, this put option gives the holder more than 24x the nominal buying power spent on the option. For this reason, options are highly effective.
The issue here is that when we're buying volatility protection, we don't have a clear and present catalyst. The catalyst is the threat of doom and destruction that may or may not come during the life of the option. This threat alone, however, is not sufficient reason to waste valuable premium under normal, low volatility, market conditions.
The solution lies in the volatility strategy known as the ratio backspread. Ratio backspreads essentially enable users to get option protection for free by selling the same option at a different strike price and using the proceeds to buy cheaper options.
Here's what a September $206/$202 put ratio backspread looks like for the SPY:
As you can see, the strategy is highly effective at providing tail-risk protection in the event of a drastic market correction, it's leveraged to provide exponential returns and the options are highly liquid and very manageable. Also, in the case of a non-falling market, the costs of holding this strategy is negligible.
In an episode of 'Friends', after discovering that his apartment had been robbed, Chandler was asked what his insurance company said; to which he replied... "they said, 'YOU DON'T HAVE INSURANCE HERE, SO STOP CALLING US!'"
However trite the allegory, it illustrates the need we all have to be protected.
At one point or another, everyone's heard that the best way to invest is to buy and hold. The idea being that the longer an investor's time horizon, the less exposed he or she is to random events or deviations from an expected return. While this approach seems simple enough, it is (more often than not) difficult for investors to simply turn a blind eye to the drastic impacts short term market volatility can have on their retirement, college and general savings. Possibly more difficult is for an endowment, foundation or pension to meet immediate obligations when years worth of contributions and returns are wiped out in the relative space of the blink of an eye.
THEORY vs REALITY; DEVIANCE vs FEAR
Volatility is formally defined as a 'measure of dispersion of returns for a security or market index.' Besides being incredibly boring, the biggest problem with this description is that it doesn't distinguish between positive and negative deviations... and why should it? Nobody's afraid of positive deviations... positive deviations, like finding a twenty dollar bill in your coat pocket, are pretty awesome.
However, like most things, volatility acts very differently IRL (that's 'In Real Life' for all non millennials). In fact, most millennials may be acutely unaware of what real volatility looks like because they were still in school the last time American equity markets experienced any. In real life, volatility is fear. Fear that swift and unforeseen market movements will erase hard earned returns and principal.
BUY UMBRELLAS ON SUNNY DAYS
If you've ever been walking around Manhattan when a random rain storm hits, you know just how fast the price of those little pocket sized umbrellas can skyrocket... only for them to break 3 days later and be rendered useless.
It's axiomatic that investment protection needs to be in place before the storm... because when things go wrong, the only thing moving faster than the red numbers at the bottom of your screen is the price being charged to protect what's left in your book.
I'm going to evaluate three types of volatility hedges designed to protect against systemic corrections. The three methods are: volatility ETFs, cash securities and option overlays. Each method will be considered on the merits of effectiveness and manageability.
VOLATILITY ETFs
Exchange Traded Funds tied to volatility are one way of buying protection for your portfolio and they are available with a myriad of risk characteristics ranging from the mild-mannered medium term/non-levered (VXZ) to the short-term/ultra levered, roid raging, rip your face off (UVXY).
In terms of effectiveness, volatility ETFs are very good at reacting to changes perceived market risk. Their prices are tied to the VIX which is a futures contract based on the implied volatility in S&P 500 options. When markets start to get uneasy and traders are taking liquidity out of S&P puts, the VIX (and by extension) volatility ETFs will respond rapidly and exponentially.
This all sounds great but there are major downsides to volatility ETFs. In terms of manageability, the only thing they have going for them is their liquidity... these things get traded a ton and the spreads are congruently thin. The downside, however, lies in timing. Since the VIX is priced off of futures contracts, volatility ETFs are subject to a phenomenon known as contango. Contango occurs because of the time decay in the futures contract... just like an option, the extrinsic premium associated with a derivative erodes as it nears expiration unless the underlying asset price exceeds the strike and premium charged at the time of purchase. When the VIX rolls over to the next monthly contract, it basically sells the old contract low and buys the new contract high (unless there has been an increase in implied volatility).
To give some color on how erosive contango can be, consider the UVXY (the one jacked up on steroids ready to rip your face off)... as of last Friday's close, the price was $29.11. Using this as a baseline, the price of this ETF 6 months ago would have been over $125. Basically, they just keep doing reverse splits on this thing every time it gets close to being a penny stock. The last reverse split sent the price from less than $10 to over $40... that was literally just a few weeks ago.
Here's what contango looks like:
To make these ETFs work, you have to time your executions perfectly... from buying just before implied volatility picks up and selling just as sentiment is bottoming out. Needless to say, this is difficult at best.
Basically, these things are like a tattoo you got in college. It seemed like a good idea at the time but it's aged badly, you're ashamed to let anyone know you've still got it and it's going to be expensive to get rid of.
CASH PROTECTION
The saying goes that 'cash is king.' Whoever said this wasn't speaking in the context of using cash securities to hedge market volatility.
Before I get into it, I want to clarify that I'm not talking about relative value or portable alpha types of trading where indices are shorted in direct relation to a basket of underlying securities (presumably with no basis risk 'wink, wink' (I don't do emojis)).
Shorting a cash index ETF, like the SPY, to hedge a portfolio of securities isn't as bad as an idea as it sounds... it is, in fact, slightly less worse than it sounds.
In almost a direct contrast to using volatility ETFs, shorting cash instruments is largely ineffective because of the absence of leverage. Leverage is everything in asset protection. Using an option with a leverage factor of 10x, I can limit a position to an eleven hundred dollar loss using only one hundred dollars. This is why I go to great depths to detail leverage in the option overlays on the swing trades I've posted on this blog. Short index trades designed to hedge a basket of long securities are typically held in relative proportion to other components of the portfolio. When markets turn down, they are assured of providing relief but only in direct relation to their size within the book.
The benefit to cash protection is solely in its manageability. Losses on the short can typically be easily offset by gains in the portfolio's long holdings. Liquidity of index ETFs also tends to be excellent. Because they're cash instruments and not related to a derivative, they don't lose value with time... investors can hold short cash hedges basically as long as they want. The lack of overall protection, however, renders this type of hedge (manageable as it may be) largely ineffective.
OPTION OVERLAYS; OF CATALYSTS AND CRISES
Finally, there's the option overlay strategy. Unlike the previous two means of gaining volatility protection, options are the both effective and highly manageable... assuming you know what you're doing.
Mostly every successful options trader will only buy an option in the event of some form of catalyst... something that will move the price of the underlying asset sufficiently far and sufficiently fast enough for him or her to realize a substantial profit. As I mentioned before, the key to protection is leverage and options are all about using leverage to achieve outsized returns.
Here's a chart that I've used before that shows the relationship of option leverage to time to expiration on a September SPY $206 strike put (SPY closed Friday directly at $208):
As you can see, this put option gives the holder more than 24x the nominal buying power spent on the option. For this reason, options are highly effective.
The issue here is that when we're buying volatility protection, we don't have a clear and present catalyst. The catalyst is the threat of doom and destruction that may or may not come during the life of the option. This threat alone, however, is not sufficient reason to waste valuable premium under normal, low volatility, market conditions.
The solution lies in the volatility strategy known as the ratio backspread. Ratio backspreads essentially enable users to get option protection for free by selling the same option at a different strike price and using the proceeds to buy cheaper options.
Here's what a September $206/$202 put ratio backspread looks like for the SPY:
As you can see, the strategy is highly effective at providing tail-risk protection in the event of a drastic market correction, it's leveraged to provide exponential returns and the options are highly liquid and very manageable. Also, in the case of a non-falling market, the costs of holding this strategy is negligible.
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