Harvesting Volatility Risk Premium

Harvesting Volatility Risk Premium (VRP) – aka Selling Vol

This paper from Parametric covers three ways to sell equity vol:

  • Index options
  • Variance swaps
  • VIX futures

My Summary and notes from Parametric Portfolio:

Selling Index Options [ex: SPX, RUT, VIX]

He looks at selling straddles and strangles using 20 delta options. 20 delta options are generally far enough away from where the underlying asset is trading that they shouldn’t (but they definitely can) go in the money – while still having enough risk that they hold some value. I.E. 20 delta options are seen as a good risk/reward balance.

Selling straddles and strangles is essentially a bet that implied volatility (at the level you sell) is higher than the realized volatility of the asset. Essentially if you sell the option and the option moves in a major way you could lose. If the stock flat-lines, you should come out ahead.

According to the author selling index options has less volatility than selling variance swaps and/or futures. And if the options are fully collateralize you reduce the chance of margin issues. (You can definitely have a “cash secured”  short put, but I don’t think there is such a think as a cash covered short call, because you have essentially unlimited risk).

He calls options “an impure form of trading volatility” because the options are only “indirectly linked to volatility.” The options price is ultimately determined by price of the underlying. I would agree with this in regards to stock options, and some index options however I would say that might not be as true with VIX Index options. (VIX is linked to the value of rolling 30 day options on the S&P500).

Finally he says that “it can be daunting for inexperienced investors to manage an option strategy”. But variance swaps aren’t?

Variance Swaps

The “swap” in “variance swap” is a misnomer as there are no cash exchanges for the duration of the trade. The variance swap has a fixed strike and expiration. The value of the contract is based on the difference between the “realized variance (volatility squared)” of a given asset (usually an index like the S&P500) and the strike level. The value of the variance swap is related to the vega notional which is a metric used to determine the sensitivity of a derivatives value to the changes in volatility.

Essentially its a more “pure” bet strictly on the volatility of an asset. The seller of the variance swap bets the buyer that volatility will stay under x level. These are called OTC (over the counter) trades and are generally left to banks, hedge funds and the like. The author says these are “the purest” form of trading volatility. They are also easy to leverage and can be tailored to meeting investors specifications.

The downside of these contracts are the “quadratic form of the payoff function”. Which essentially means that the returns are “convex” or upward sloping. A stock for instance has a linear payoff – you make $1 per share if they stock goes up 1 point. When volatility really spikes the variance swap (and all options for that matter) can start with a return of $1/pt then quickly rise to return 4,5,6 and up per point. Put another way its a curved upward sloping (convex) payoff, not a straight line.

VIX Futures

Derivatives linked to VIX offer investors a “direct approach to monetize the premium embedded in equity volatility” as the VIX is linked to the S&P500 index options. He alleges that VIX futures are more popular than variance swaps. The VIX futures are a popular form of “tail risk” insurance, but its expensive as they contango of the VIX futures curve makes it expensive to own. I.E. owners of VIX futures lose every month rolling the futures in a “normal” environment. So if you were to sell you might make profit on this roll.

VIX Futures Curve

VIX futures are very liquid and are a pretty pure play on volatility. The futures can be very volatile in the short term, distorting  pricing. There is a strong equity beta towards VIX futures (linked to the movement of the S&P500). Notional exposure of VIX futures is expressed in vega (as in variance swaps).

The Returns:

I heard someone once say “no one ever lost money backtesting”. I agree, so take the returns below with a grain of salt. In reality you have issues to deal with when actually trading this stuff – margin calls, transaction fees and the like. That being said you can see the significant drawdown on the variance swap. Linking back to the authors note about the “convexity” of the variance swap gain/loss …I would not want to be on the wrong side of that trade.

short volatility returns

Paris Shooting

Police offers were just shot in Paris, 3 days before the election. Volatility sold off all day and the US market rallied as the latest polls gave Macron a better lead.

Paris Shooting
Paris Shooting

The French have no said who is responsible – but *if* its a terrorist (as in Islamic) attack will that substantially swing things? You’d have to think that this tilts things slight more toward Le Pen…

The close today might have been a great time to add some hedges as the markets could react sharply overnight on this.

Social Media & Algos

There was an interesting post on Price Action about a particular stock that was much more volatile than normal. The author alleged that this was due to social media. While algos reading social media and trading is nothing new its not often that someone lays out an example. Anecdotally I’ve heard of very successful traders who make their money just being faster scraping news sites or jumping on these social media trends than other algos. This is a long way from the Buttonwood Tree

Here is the weekly chart for some context:

ORLY chart

From Price Action:

Dumb Social Media Sentiment Algos Target The Stock of O’Reilly Automotive

Increased volatility in the stock of O’Reilly Automotive (ORLY) in the last two days while the name O’Reilly was trending in the news raises questions about the effectiveness of social media sentiment algos and their perils.

There is a small probability that the two events are unrelated and the stock of O’Reilly Automotive (ORLY) rallied in the past two days because of normal market activity but this happening while the name O’Reilly was trending in Twitter and social media raises some questions about what is really happening in Wall Street. What are the risks from dumb algos taking over Wall Street?

Yesterday, the stock rallied as much as 3% from the previous close. It appears that some market participants realized the irrational behavior and sold for quick profit. The stock closed up 1.1% on the day.”

End Price Action

What really impacted me recently, though was an article about ESPN on Businessweek. Social media major influences, in almost real time, what ESPN broadcasts:

At a standing desk in a corner office, King, 54, is staring at a screen that displays what looks like a stock chart. It’s ESPN’s “Producer Panel,” custom software for tracking what viewers are talking about on social media. A blue line represents the Brady story; a yellow one represents the upset by South Carolina over Duke in the college basketball tournament. King hits a few keys and adds Houston Rockets guard James Harden to the mix of trending topics. Harden made news the day before by wading into a debate about rest for NBA players; today he’s gaining ground on the missing jersey saga, which makes him prime fodder for the evening broadcast.”

On its face its hard to argue with the philosophy of letting social media (and by extension, your viewers) influence whats “news” and/or control the narrative. Yes, sports is not really “news”. I’m willing to bet that purveyors of news (CNN, FOX, etc) use very similar systems – that is letting social media control the narrative in real time.
What happens here when you have sites like Facebook and Twitter (which control who sees what)? This ties into the whole “Fake News” meme. You could start to end up with this weird feedback loop where who controls social media controls whats on the news which then regenerates what people are “tweeting” about.
Its more important now that ever to use critical thinking and to understand what it is thats happening. Why and how stocks and markets are moving may not be obvious – and the cited reasons for their movement might be specious. I find this particularly prescient at this moment when the French elections start Sunday and the outcome is absolutely anyone’s guess.
French Polls

Why Short Volatility Is So Popular

Hedge Funds in general have had a tough go the last few years. One segment that has had arguably the worst ride of all is Long Volatility Hedge funds. As you can see by the CBOE Eurekahedge Long Volatility Hedge Fund Index, its been ugly. While I don’t pretend to be a professional market technician, that chart is not pointing in the right direction.

CBOE Long Volatility Hedge Fund Index

If you look at all their “volatility” funds you can actually see tail risk is measurably worse.

CBOE Volatility Fund Index

Now, compare this to short volatility funds. If this was a stock you’d probably want to buy it. This chart makes it easy to understand why so many jump on the “short vol train to easy alpha”.

CBOE short volatility funds

Many attribute the lack of recent volatility to the “Central Bank Put” which was the markets general belief that any drop in prices would be met by Central Bank support.

The Fed has hinted  that it might start to reduce its balance sheet. That doesn’t mean the “put” is gone, but its not as sure of a thing. Much like the European Union, its still there, but its not so sure of a thing.


My point is – we’ve had a very consistent and stable world. Stock markets are at all time highs. Post 2008 investors could more or less know what to expect tomorrow. To me it seems like that tide is turning. Regimes are changing.

I think some of this risk will start to show up in the form of a higher “volatility equilibrium” closer to what we saw just after the 2008 crisis.

As a way of visualizing the chat below shows that we are currently in rough range of 10-15 VIX, with a floor of 10.For sake of argument lets say that was an average of 12.5. The volatility of volatility appears to have tighter range than say 2008-2012.

From 2008 to 2012 the floor was 15 and the average is clearly higher. Lets say for ease of argument the average was 20.

VIX equilibrium

I think this new, higher volatility equilibrium is somethign to keep a keen eye on as the results of any number of major shifts, for example:

  • Effects of “populism” and shifts out of EU
  • Trumps ability to “get stuff done”
  • Interest rate changes
  • Fed policy changes




US Volatiltiy Takes a Breather

The VIX is back under $14 this morning, but the European VIX (V2X) is not. To me it doesn’t now seem worth putting on any large positions with the elections coming up. Now that US volatility has come in quite a bit it doesn’t seem great risk/reward shorting it either. Cash is a position as they say.

V2X year chart

EU Volatility vs US Volatility

The V2X VSTOXX Index is based on the EURO STOXX 50 Index – like VIX but for Europe.

Compare the term structure of the V2X (top courtesy of Bloomberg) futures to VIX(bottom, vixcentral.com).

V2X term structure

V2X came into April with a 16 handle, so it is much more elevated than VIX at this time. As its so expensive to hedge in the EU I think this is turning traders to use the VIX as it is cheaper.  Couple that with the fact that yesterday was a EU holiday and volatility was sold hard. This is hinting that a lot of the hedging demand is non-US.

If there is an upset in the French election that would certainly hit US markets but not as hard obviously as EU. Keep in mind for there to be an upset one candidate would have to have over a 50% vote which seems very unlikely. My ignorant bet is that nothing final comes from next weeks election and that pushes the decision to May 7th. We would then see a selloff in volatility as traders have to roll out protection.

A Backward Contango

Despite a selloff in volatility land yesterday there is still a strange “backward contango” in VIX futures caused by the French Elections. In normal times you would see “backwardation” in the chart below (blue line). This means the April VIX future woudl have a lower price than May. However April is higher than may, again, most likely due to the French elections. This could work against you if you are using short volatility ETPs and with you if you’re long VXX or another long volatility ETP. Explained here and here.

VIX Contango

Currently according to the VXX website April futures are a very small component of the holdings. As May VIX futures prices are less than spot VIX (green line in the chart above) this means you might not collect on the “reversion” or decay of the futures to VIX. To me this means shorting VXX isn’t as juicy here as 15/16 handle VIX might imply.

VIX Futures Roll

XIV, the short volatility ETF has basically the same futures allocation. Again because of the weird VIX futures curve when you are buying XIV you are long mainly May futures which are less in price than spot VIX. I don’t think this is an advantageous product to use to short volatility at this moment because of this inversion.

XIV allocation

Short Term Vol Top In?

Without any new catalysts to push people into hedging its hard to see what ramps volatility higher here. Adding new hedges at this point is quite expensive relative to a week ago.

Many of the volatility ratios are starting to move back into their ranges. Below is a ratio of VIX to “Short Term” VIX which measures 9 day volatility.

Plus you know there are lots of dollars waiting to short this volatility spike – so when it starts to fade it’ll fade quickly.

Whats wrong with your Volatility Products (ETPs)

Many who trade in the volatility products (ETF’s and ETN’s etc) do not understand how the products work. If you don’t believe me just spend a few minutes on the Stocktwits VXX feed. Complaints usually relate to “the VIX moved and my [insert VXX, SVXY, TVIX, XIV, etc] didn’t move. This is market manipulation and or conspiracy.” There are dozens of articles about why these things don’t track the VIX, here’s one. What interest me is different.

Embedded in the prospectus of XIV is a clause that allows the ETP provider (Velocity Shares) to effectively terminate the leveraged product if there is “more than an 80% move” in the underlying futures. For leveraged products (i.e. 2x volatility) its only a 40% move. Note: this doesn’t specific DIRECTION it just says MOVE. So you could be correct in the direction (i.e. long XIV when volatility spikes) and still lose. I haven’t looked at other prospectuses, yet.

From the XIV prospectus (gotta love the term “Event Acceleration”):

“Sensitivity of the ETNs to large changes in the market price of the underlying futures contracts Because the Inverse ETNs and 2x Long ETNs are linked to the daily performance of the applicable underlying Index and include either inverse or leveraged exposure, changes in the market price of the underlying futures will have a greater likelihood of causing such ETNs to be worth zero than if such ETNs were not linked to the inverse or leveraged return of the applicable underlying Index. In particular, any significant increase in the market price of the underlying futures on any Index Business Day will result in a significant decrease in the Closing Indicative Value and Intraday Indicative Value of the Inverse ETNs, and any significant decrease in the market price of the underlying futures on any Index Business Day will result in a significant decrease in the Closing Indicative Value and Intraday Indicative Value of the 2x Long ETNs. If the price of the underlying futures contracts increases by more than 80% in a day, it is extremely likely that the Inverse ETNs will depreciate to an Intraday Indicative Value or Closing Indicative Value equal to or less than 20% of the prior day’s Closing Indicative Value and will be subject to acceleration if we choose to exercise our right to effect an Event Acceleration of the ETNs. If the price of the underlying futures contracts decreases by more than 40% in a day, it is extremely likely that the 2x Long ETNs will depreciate to an Intraday Indicative Value or Closing Indicative Value equal to or less than 20% of the prior day’s Closing Indicative Value and will be subject to acceleration. If the price of the underlying futures contracts decreases by more than 80% in a day, it is extremely likely that the Long ETNs will depreciate to an Intraday Indicative Value or Closing Indicative Value equal to or less than 20% of the prior day’s Closing Indicative Value and will be subject to acceleration if we choose to exercise our right to effect an Event Acceleration of the ETNs”

Several years ago there was a class action lawsuit against Credit Suisse due to the rapid decay in their TVIX product.


Feb 2012:

“Credit Suisse, the sponsor behind the VelocityShares Daily 2X VIX Short-Term ETN (NYSEArca: TVIX), temporarily suspended creations of shares of the exchange-traded note because assets in the security had grown beyond what the bank, in a press release, called “internal limits.”

This all plays into a future event I see coming which I’ve dubbed “volivator”.

My point is this:

Know what you’re trading – if you don’t understand it then you have no business trading it.

Pensions “Transferring Risk”

Several items in this article from CIO caught my eye. Article pasted in below, but essentially corporate pensions had a better return last year than expected, and were also aided by a drop in life expectancy. Pensions obviously have huge liability issues with many of them underfunded. The idea that shortening life spans might help ease the pain is one [very sad] variable that hadn’t occurred to me.

Life Expectancy

What was also interesting was that pensions were able to “transfer pension risk to insurance companies”. This concept was new to me. Apparently the pensions can purchase annuities from insurance companies which cover some of their risk. The pensions can also offer lump sums to the pensioner. Both of these strategies allow the pensions to have more defined benefits going forward.

Here is a primer on one way the pensions transfer risk:

Annuity Transfers


  • Employers make a deal with an annuity provider, usually an insurance company, to transfer a certain amount of plan assets, plus pay additional fees, in return for monthly payments to plan beneficiaries when they retire.
  • Participant consent is not required.
  • Retirees’ monthly payments are the same as they would be under the plan, but they are made by the insurer and are not guaranteed by the federal Pension Benefit Guaranty Corporation.
  • Employers must choose their providers carefully with documented due diligence under the guidance of an independent plan fiduciary.

Full article below:

More Corporate Pension Plans Transferring Risk, Milliman reports

Despite fluctuations, the largest pension plans ended 2016 with their funded ratios little changed.

The 100 largest US corporate pension plans saw their funded status drop to 81.2% for 2016, from 81.9% a year earlier, according to actuarial firm Milliman. The $21.7 billion drop in funding resulted from a rise in projected benefit obligations, partially balanced by a rise in the market value of plan assets.

The 100 plans also witnessed quite a bit of volatility in 2016, Seattle-based Milliman reported. “Investment performance exceeded expectations, with the 100 largest US pensions experiencing returns of 8.4%—compare that to 0.8% the year prior,” said Zorast Wadia, an actuary and co-author of the pension funding study, “but the volatile interest rate environment saw the discount rate plummet by 30 basis points. In 2016, these dynamics resulted in a funded ratio that oscillated back and forth for most of the year before the post-election bump. The end result was a funded ratio of 81.2%—not that far off from where we’ve been at the end of 2015 and 2014.”

Three factors buoyed the 100 largest corporate plans. One was an investment return of 8.4% for 2016, outperforming expectations. Another was employer contributions, which rose 38% from 2015 levels. A third was a decline in estimated life expectancies for the second year in a row, which helped cut projected benefit obligations at several of these companies.

Some companies are planning to adopt an accounting change to cut their pension expenses for fiscal year 2017. This entails moving to spot interest rates that are based on the yield curves of high-quality corporate bonds. For 2017, 46 companies in the Milliman study said they intended to adopt this practice, compared to 37 companies for 2016.

Plan sponsors also boosted their engagement in strategies to transfer pension risk to insurance companies. Pension risk transfers, together with pension risk settlement payments to former plan participants who are not yet retired, rose to $13.6 billion in 2016, from $11.6 billion in 2015 and included such companies as Westrock, United Technologies, PepsiCo, Hewlett-Packard, International Paper, and Verizon. By doing so, plan sponsors also cut down on their required premium payments to the Pension Benefit Guaranty Corporation.