Long Volatility as an Investment

[wayneL]

Those of us involved with options are aware, or should be, about the intrinsic vector of the pricing of volatility.

A few months ago I briefly mentioned the investment strategy known as the Hawk and The Serpent, as proposed by Chris Cole of Artemis Capital

Chris' thesis is having a strategic allocation of capital roughly 25% as long volatility.

Others such as Nick Taleb I have also employed a similar thesis with success.

Those of us in the optionosphere know long volatility as being long Vega, but what does this mean in practical terms?

The most basic manifestation of long vega is being long puts on a portfolio, however simply being long puts it's a tremendous drag on portfolio performance when the market is in a extended bull phase.

Like insurance, it costs money... And depending on how you structure it, that cost may be prohibitive.

So has an intellectual exercise I think it would be an interesting discussion to explore how one may become "long volatility", without having to time volatility events... How one may construct volatility into a long-term portfolio.

I have some ideas, but over to you guys, what do you think?

 

[cutz]

Interesting discussion mate.

Firstly I need to have a look at the strategy you discussed, a link would be great, I've had to throttle back at the moment due to events in my life.

Couple of points on the fly, long volatility has to be on at all times, this takes some huge discipline and patience, something I'm a little short of.

Little example of mine, back at the start of the year I was actually long volatility, there was talk of the virus and I had accumulated long index puts, remnants of previous strategies plus more, with almost perfect precision I closed out to cash what little extrinsic value was remaining then the market finally plunged, I spent months thinking about what could have been !

Back to topic, index backspreads look good on paper but I never had any real success with these, how about call spreads against your holdings using the credit to buy WTFOTM index puts, robotic like discipline required to ensure those puts are always on ?

 

[wayneL]

@cutz search "hawk and serpent Chris Cole" on yoootooob and it will bring up several interviews and analyses regarding Chris Coles thesis and various ways of being long volatility in a portfolio.

That's the best way, I just don't have a single link that encapsulates the whole thing.

For The longest time, Taleb has been trading a similar idea, though I think a little bit more simple approach. You are right that it does require patience, volatility explosions seldom happen.

I think this is why Cole's thesis is to keep it as only part of a portfolio.... IIRC, 25% Bonds, 25% Equities, 25% precious metals, and 25% long vol. (Personally I would shoehorn some bitcoin in there somewhere, perhaps in the precious metals allocation?)

The idea seems to be that when everything else is blowing the **** up, as we saw earlier this year, the long volatility and the positive gamma will offer a substantive hedge and possibly even a nice little profit centre.

The trick is in constructing it so that it does not whiteant returns in the meantime. I think long dated back spreads fit the bill here, readjusted at appropriate times.

2, 3, 4...... 10 sigma events tend to happen too quickly for we mere mortals to be smart asses and trade to advantage. At least it is for me, extreme volatility is difficult to trade in my opinion.

That strategic long vol position could just be the thing having us kicking back, pouring a nice glass of Shiraz and just watching everything unfold with a smile on our face.

 

[cutz]

Hi Wayne.

Found a macro voices you tube from back in Feb when talk of the virus was in its infancy, had to bail at 10min due to other committments, I'll get back to it tonight, it's around one hour long.

Your back spread idea ok, especially if it can be done for a credit, I do recall you have success with these, trick is staying out of the hole heading into expiry, normally I manage to fail.

You expecting something in the near term ? The vaccine rally is making me nervous..

 

[chips88]

I believe there is also an allocation to commodity trend in the portfolio. With roughly 20% allocations on each asset class?

I am also in the search for what long volatility is as an asset class, its hard to get the head around and there is not much info online about what strategy's to use, but I have come across using an options straddle strategy, which basically profits on any large move of the underlying, in any direction it ends up going.

From what I can gather it is a slow bleed on your account but when it pays off in times of crisis, or bubble for that matter, it pays off big.

Full disclosure, I have never traded options and am only going off what I have read from papers online like Chris Coles one.

 

[wayneL]

I believe there is also an allocation to commodity trend in the portfolio. With roughly 20% allocations on each asset class?

I am also in the search for what long volatility is as an asset class, its hard to get the head around and there is not much info online about what strategy's to use, but I have come across using an options straddle strategy, which basically profits on any large move of the underlying, in any direction it ends up going.

From what I can gather it is a slow bleed on your account but when it pays off in times of crisis, or bubble for that matter, it pays off big.

Full disclosure, I have never traded options and am only going off what I have read from papers online like Chris Coles one.

Yes you are correct, I had completely forgotten about the commodity trend trading allocation.

Straddles/strangles are indeed long vol, but the vega pump effect is asymmetric 99% of the time, Hence why, until some smarty comes up with a better solution, I am thinking about long dated put back spreads.

If the world turns to ****, you get the benefits of both +Vega and +gamma.

If wall street is overdosing on methamphetamines, your long equities are raking it in, and your put back spread comma depending on vols at the time and how you construct it, is essentially breaking even or there abouts... Perhaps even modestly profitable.

If you find yourself in the valley of the shadow of death, you can just wait it out for a move, or restructure. This is the advantage of long dated structure, dodging the majority of theta.

 

[wayneL]

Hi Wayne.

Found a macro voices you tube from back in Feb when talk of the virus was in its infancy, had to bail at 10min due to other committments, I'll get back to it tonight, it's around one hour long.

Your back spread idea ok, especially if it can be done for a credit, I do recall you have success with these, trick is staying out of the hole heading into expiry, normally I manage to fail.

You expecting something in the near term ? The vaccine rally is making me nervous..

My thesis is that there's going to be a bukkake of liquidity... They are going to try to inflate their way out of this, so I don't anticipate any sort of stock market crash anytime soon (EVEN IF IT SHOULD).

But.... Chaos theory.... a butterfly flapping its wings in San Francisco can cause a tempest in Tokyo... So who the hell knows, a six sigma event could happen at any point.

 

[Value Collector]

@cutz search "hawk and serpent Chris Cole" on yoootooob and it will bring up several interviews and analyses regarding Chris Coles thesis and various ways of being long volatility in a portfolio.

That's the best way, I just don't have a single link that encapsulates the whole thing.

For The longest time, Taleb has been trading a similar idea, though I think a little bit more simple approach. You are right that it does require patience, volatility explosions seldom happen.

I think this is why Cole's thesis is to keep it as only part of a portfolio.... IIRC, 25% Bonds, 25% Equities, 25% precious metals, and 25% long vol. (Personally I would shoehorn some bitcoin in there somewhere, perhaps in the precious metals allocation?)

The idea seems to be that when everything else is blowing the **** up, as we saw earlier this year, the long volatility and the positive gamma will offer a substantive hedge and possibly even a nice little profit centre.

The trick is in constructing it so that it does not whiteant returns in the meantime. I think long dated back spreads fit the bill here, readjusted at appropriate times.

2, 3, 4...... 10 sigma events tend to happen too quickly for we mere mortals to be smart asses and trade to advantage. At least it is for me, extreme volatility is difficult to trade in my opinion.

That strategic long vol position could just be the thing having us kicking back, pouring a nice glass of Shiraz and just watching everything unfold with a smile on our face.

I pretty much have the exact opposite take to Chris, I am about 20% realestate, 5% fixed interest, 70% equites and I operate a largish short put portfolio.

may the moment some of the companies I feel very strong about such as FMG are selling out of the money puts at at rates of over 18% at an annual rate, that is super expensive insurance in my opinion, when insurance is that pricy I prefer to be the seller rather than the buyer.

 

[cutz]

My thesis is that there's going to be a bukkake of liquidity... They are going to try to inflate their way out of this, so I don't anticipate any sort of stock market crash anytime soon (EVEN IF IT SHOULD).

But.... Chaos theory.... a butterfly flapping its wings in San Francisco can cause a tempest in Tokyo... So who the hell knows, a six sigma event could happen at any point.

@wayneL , I am actually in the process of simplifying my portfolios, the past week has enabled me to fast-track the process, XJO backspreading is something I would like to have another look at, looking at the Feb 6000/5700 puts 1:2 ratio can be done for zero cost, if vols continue to collapse maybe a credit, I've also got some leftover long puts expiring Nov and Dec, I'll resist the urge to close these out for a pittance.

 

[cutz]

I pretty much have the exact opposite take to Chris, I am about 20% realestate, 5% fixed interest, 70% equites and I operate a largish short put portfolio.

may the moment some of the companies I feel very strong about such as FMG are selling out of the money puts at at rates of over 18% at an annual rate, that is super expensive insurance in my opinion, when insurance is that pricy I prefer to be the seller rather than the buyer.

He has an extremely dim view on buy write and naked put strategies, I learnt the hard way with covered calls, selling out upside is a nice way of putting it.

 

[Sharkman]

i would imagine that simply buying calls or puts (or both) outright and constantly maintaining that position by buying more to replace the previous ones when they expire is not sustainable in the long run, your capital just gets gradually eaten up by decay, and you're basically relying on a huge blowup happening sometime for it to make money. if it's considered as a form of "insurance" it's probably ok, but if it's considered as an "investment", it's a crapshoot.

IMHO it'd be hard to make that even sustainable, let alone profitable, if one is constantly buying options straight up in a monotonous manner and simply paying the decay. even if buying longer dated options, say 1 year + (assuming liquidity/spreads aren't an issue, but they will be if considering Aust options) to reduce the decay, in a low vol environment the tenor skew tends to slope upwards in anticipation that the "tranquility" can't last forever, so you probably don't even get the full benefit of that low vol environment when going long dated. and that's a lot of premium to outlay if buying long dated options in a high vol environment.

which probably necessitates having to find a way to defray the cost of the bought premiums somehow. roll the dice on a calendar/diagonal and try to get the back leg to "on the house" status, netting you "free protection" until it expires, and hope that you don't get caught with your pants down if it gaps thru the support/resistance levels that you based the front leg on before the front leg rolls off? or don't maintain the protection constantly, but instead only use it strategically at points where you feel the rest of the portfolio needs the protection, and fly unhedged the rest of the time? that all needs some element of timing though.

maybe i've been looking at it the wrong way. you said long vol, but not necessarily long gamma/short theta. so maybe something wacky like a ratio diagonal might do the trick, where you buy a certain number of longer dated OTM calls/puts netting a lot of vega, then keep selling a smaller number of shorter dated ATMs against it to neutralise most/all of the gamma/theta while keeping most of the vega? possibly then salt to taste by buying/selling underlying if one wants to be delta neutral as well?

don't really know, just theorycrafting here as i've never tried shooting for a pure +vega position in an actual trade before. seems like a lot of effort to have to constantly square up the risks you don't want to leave only the one risk that you do want, so transaction costs (plus the cost of your own time, which shouldn't be forgotten) are a factor here. and would probably need a good understanding of how the delta and tenor skews behave under various conditions (eg. before/after earnings reports, macro stuff like interest rate moves etc.) for the chosen underlying, if the skew does the opposite of what you want, that probably wrecks this sort of strategy.

i'm primarily a covered call/cash covered put seller though, so not all that familiar with the nuances of vol plays, i don't really make them very often. keen to hear how other traders would approach this sort of scenario, i definitely have a lot to learn in this area.

 

[cutz]

My thesis is that there's going to be a bukkake of liquidity... They are going to try to inflate their way out of this, so I don't anticipate any sort of stock market crash anytime soon (EVEN IF IT SHOULD).

Yep,

The amount of irrational exuberance in this week's market is extraordinary, not something I wanna bet against ( as in delta 1 index shorts ), the vaccine was just the trigger for a whole load of backdriving !

 

[wayneL]

I pretty much have the exact opposite take to Chris, I am about 20% realestate, 5% fixed interest, 70% equites and I operate a largish short put portfolio.

may the moment some of the companies I feel very strong about such as FMG are selling out of the money puts at at rates of over 18% at an annual rate, that is super expensive insurance in my opinion, when insurance is that pricy I prefer to be the seller rather than the buyer.

One must understand what is trying to be achieved with the dragon portfolio. Short volatility such as covered calls and short puts is a completely different approach, which should rightly be discussed on a different thread to this.

The Dragon portfolio is intended to be a strategy which is implemented and maintained on a lifelong basis, perhaps even multi-generationally.

What we are specifically talking about with this aspect of the dragon portfolio ie long volatility, is tail risk. The dragon portfolio is nothing less than a true personal hedge fund, in its original sense.

Net short options exposes you to tail risk, long volatility strategies hedge against and/or benefit from multi-sigma events.

If you are short puts whether that is synthetic or not, the world turning to merde is a cause for extreme panic and quick action to keep you out of the bankruptcy courts.

Long vol means you can order another pina colada, sit on the beach improving your suntan and enjoy watching everybody else sh17 themselves.

In theory anyway.

If you can construct it with enough gamma, and in conjunction with other aspects of the portfolio you may even be able to put a deposit on the Roller and the digs in St Bart's nextdoor to Hugh Hendry.

We want to be Eclectica, not LCTM

 

[Value Collector]

One must understand what is trying to be achieved with the dragon portfolio. Short volatility such as covered calls and short puts is a completely different approach, which should rightly be discussed on a different thread to this.

The Dragon portfolio is intended to be a strategy which is implemented and maintained on a lifelong basis, perhaps even multi-generationally.

What we are specifically talking about with this aspect of the dragon portfolio ie long volatility, is tail risk. The dragon portfolio is nothing less than a true personal hedge fund, in its original sense.

Net short options exposes you to tail risk, long volatility strategies hedge against and/or benefit from multi-sigma events.

If you are short puts whether that is synthetic or not, the world turning to merde is a cause for extreme panic and quick action to keep you out of the bankruptcy courts.

Long vol means you can order another pina colada, sit on the beach improving your suntan and enjoy watching everybody else sh17 themselves.

In theory anyway.

If you can construct it with enough gamma, and in conjunction with other aspects of the portfolio you may even be able to put a deposit on the Roller and the digs in St Bart's nextdoor to Hugh Hendry.

We want to be Eclectica, not LCTM

yep, I understand the strategy, it’s basically taking some of the cash generated from other sources (or capital) and using it to buy insurance against a negative event in the future.

like all insurance, it’s smart at one price and silly at another, and just like insurance you can make it cheaper by accepting a larger excess.

thats why I mentioned at certain prices I would rather be selling insurance.

As I said 3 days ago I saw that out of the money put options on a share I follow we’re selling for over 18% of the strike price on an annual basis, from an insurance perspective, that means after roughly 5 years the put option seller would have collected the entire strike price as premiums, and the stock price could go to $0 and he would still break even.

of course cheaper options could be purchased deeper out of the money, but the person seeking insurance is essentially accepting a larger excess payment and reducing the number of times this policy will be profitable.

———————

It all comes down to margin of safety, if some one is going to take on a life time or multi generational insurance policy, where they are paying out regular fees to counter parties, they have to be sure that those fees make sense compared to how often the events occur in which their policy is triggered.

 

[wayneL]

yep, I understand the strategy, it’s basically taking some of the cash generated from other sources (or capital) and using it to buy insurance against a negative event in the future.

like all insurance, it’s smart at one price and silly at another, and just like insurance you can make it cheaper by accepting a larger excess.

thats why I mentioned at certain prices I would rather be selling insurance.

As I said 3 days ago I saw that out of the money put options on a share I follow we’re selling for over 18% of the strike price on an annual basis, from an insurance perspective, that means after roughly 5 years the put option seller would have collected the entire strike price as premiums, and the stock price could go to $0 and he would still break even.

of course cheaper options could be purchased deeper out of the money, but the person seeking insurance is essentially accepting a larger excess payment and reducing the number of times this policy will be profitable.

———————

It all comes down to margin of safety, if some one is going to take on a life time or multi generational insurance policy, where they are paying out regular fees to counter parties, they have to be sure that those fees make sense compared to how often the events occur in which their policy is triggered.

"Insurance", though essentially how options are priced via Black Scholes, Binomial, etc, is not how we are looking at this in this instance and I will raise two overarching points.

1) Expensive may be cheap and cheap may be expensive.

Let's say you pay a crapper load for long puts and your market tanks 75%. The price you paid was cheap. On the other hand if you pay a pittance and it continuously expires out of the money, it is expensive.

Implied and realised volatility scarcely matches in the real world in real time.

Again, I will cite LCTM. Expensive or cheap can only truly be determined in hindsight

2) Simple short or long options does not represent the strategy being proposed here, in general.

Such an approach is, at its core, is trading theta against delta/gamma, whether such is + or -.

Being strategically long volatility is, at it core, trading vega/gamma, with both being +, theta being largely hedged out.

Long vol does not require hindsight, merely an understanding of kurtosis and fat tails

These two things are profoundly different.

 

[Value Collector]

1) Expensive may be cheap and cheap may be expensive.

Let's say you pay a crapper load for long puts and your market tanks 75%. The price you paid was cheap.

As a one off speculation you would make money, how ever as a life long policy you definitely lose.

let’s look at an over simplified example.

lets say we were both in our early 20’s and had both just inherited $1 Million each from grandpa.

lets you wanted to invest your $1 Million is the ASX 200 index which is sitting at 6000 points, because you thought that might grow in value over time, but you wanted to insure your self against that 75% fall that might happen one day.

fortunately for you I offer to sell you insurance, All I ask is that each year you give me all your dividends on your $1 Million of asx200 index, and I will promise to ensure your portfolio never drops below your $1 Million starting level.

short term this bet might work out for you, but the longer you continue paying me your dividends, the more cash I accumulate until eventually I have a kitty with well over your $1 Millon insured sum.

 

[ducati916]

As a one off speculation you would make money, how ever as a life long policy you definitely lose.

let’s look at an over simplified example.

lets say we were both in our early 20’s and had both just inherited $1 Million each from grandpa.

lets you wanted to invest your $1 Million is the ASX 200 index which is sitting at 6000 points, because you thought that might grow in value over time, but you wanted to insure your self against that 75% fall that might happen one day.

fortunately for you I offer to sell you insurance, All I ask is that each year you give me all your dividends on your $1 Million of asx200 index, and I will promise to ensure your portfolio never drops below your $1 Million starting level.

short term this bet might work out for you, but the longer you continue paying me your dividends, the more cash I accumulate until eventually I have a kitty with well over your $1 Millon insured sum.

I believe that you misunderstand the issue from reading your example above. Staying with your example and adding 1 further assumption: that the market will show 10% compounded annual growth.

Wayne is not seeking insurance for his $1M, he is seeking insurance for 100% of his gains going forward. That is a very different proposition. So in 10yrs time you are insuring not $1M but $2.6M.

jog on
duc

 

[Value Collector]

I believe that you misunderstand the issue from reading your example above. Staying with your example and adding 1 further assumption: that the market will show 10% compounded annual growth.

Wayne is not seeking insurance for his $1M, he is seeking insurance for 100% of his gains going forward. That is a very different proposition. So in 10yrs time you are insuring not $1M but $2.6M.

jog on
duc

If you are assuming 10% compounded growth, then you must also factor in the increased lost potential of the money you paid out as insurance premiums.

eg, all those dividends you paid out to me as insurance premiums could have been reinvested at 10% compounded growth for you however instead you paid them to me. And the dividends them selves would have grown rising the premiums I charged.

———————-

Also, in reality the entire $1 million or even the $2.6 Million is not really at risk, since the index will never go to zero.

 

[ducati916]

1. If you are assuming 10% compounded growth, then you must also factor in the increased lost potential of the money you paid out as insurance premiums.

2. eg, all those dividends you paid out to me as insurance premiums could have been reinvested at 10% compounded growth for you however instead you paid them to me.

3. And the dividends them selves would have grown rising the premiums I charged.

———————-

4. Also, in reality the entire $1 million or even the $2.6 Million is not really at risk, since the index will never go to zero.


1. Incorrect. Those are being paid to you as 'insurance'. The 10% growth rate earned are purely capital gains on the initial $1M.

2. They could have been, but were not, because I took out insurance against tail risk. I transferred for that premium, all my risk to you. The insurance model is of course that you take those premiums and invest them, growing them so that if a claim is made on an expanded capital base, that you have the capital to pay my claim. The issue (for you) is that you need to meet or exceed my 10% capital growth rate p/a while concurrently hoping that any claims come later rather than earlier.

3. In some cases yes, in some cases no. That is an additional issue (risk) for the insurer.


However your example does not actually reflect the reality of the position, vis-a-vis selling Options. Options are a leveraged instrument. You are picking up pennies in profit while assuming dollars of risk in losses, hence the LTCM argument already put to you. This is relevant to your point [4]: the market does not need to go to zero to have you carried out on your shield: 22% on 19 Oct. 1987 was more than adequate to bankrupt you. More recently, this past Feb. and COVID.

@wayneL is arguing in this thread that, as a buyer of vol. you spend pennies to pick up dollars. It is psychologically an unpleasant way (although very effective) to profit from the market.

The issue for this thread is: how do you minimise your costs (losses) and maximise the returns (profits) on this model?

jog on
duc

 

[Value Collector]

1. If you are assuming 10% compounded growth, then you must also factor in the increased lost potential of the money you paid out as insurance premiums.

2. eg, all those dividends you paid out to me as insurance premiums could have been reinvested at 10% compounded growth for you however instead you paid them to me.

3. And the dividends them selves would have grown rising the premiums I charged.

———————-

4. Also, in reality the entire $1 million or even the $2.6 Million is not really at risk, since the index will never go to zero.


1. Incorrect. Those are being paid to you as 'insurance'. The 10% growth rate earned are purely capital gains on the initial $1M.

2. They could have been, but were not, because I took out insurance against tail risk. I transferred for that premium, all my risk to you. The insurance model is of course that you take those premiums and invest them, growing them so that if a claim is made on an expanded capital base, that you have the capital to pay my claim. The issue (for you) is that you need to meet or exceed my 10% capital growth rate p/a while concurrently hoping that any claims come later rather than earlier.

3. In some cases yes, in some cases no. That is an additional issue (risk) for the insurer.


However your example does not actually reflect the reality of the position, vis-a-vis selling Options. Options are a leveraged instrument. You are picking up pennies in profit while assuming dollars of risk in losses, hence the LTCM argument already put to you. This is relevant to your point [4]: the market does not need to go to zero to have you carried out on your shield: 22% on 19 Oct. 1987 was more than adequate to bankrupt you. More recently, this past Feb. and COVID.

@wayneL is arguing in this thread that, as a buyer of vol. you spend pennies to pick up dollars. It is psychologically an unpleasant way (although very effective) to profit from the market.

The issue for this thread is: how do you minimise your costs (losses) and maximise the returns (profits) on this model?

jog on
duc

since when has the market averaged 10% compounded growth excluding dividends? Especially over a life time as in Wayne’s example.

and as I said at the moment some stocks “insurance premiums” are selling for over 18%, so at that price even your 10% growth factor is dwarfed by the Premiums you are paying out.

I don’t think picking up annualised premiums of 18% of the insured value is the same as “picking up pennies”

—————
as for insuring an increasing capital base it works both ways.

the capital base would have to drop 18% in the first year to break even, if it only dropped 10% you lost, and the insurance in the second year would be based on the lower capital base.