Long Volatility as an Investment

[ducati916]

1. yes, companies went bankrupt and the Beta of their stock didn’t give any idea of the risk for the years and months leading up to that, however if you have seen the movie the Big short, you will see guys that did Manuel valuations of the underlying bonds etc figured out what was happening and profited from it.

2. Yes 8 years ago when I first started researching options I read quite a bit about about the BS formula, but yes now I couldn’t tell the what delta or gamma are, I have data dumped that because I don’t use it.

B, what losses on the options I take delivery of? I hardly think taking delivery of FMG at $5 has caused any losses, but when I do take delivery of stock, the difference between the market price and the price I paid is recorded as a loss against my options income, and the market price is recorded as my cost price for those shares I hold long term, so no I am not ignoring any losses, I know my profit and loss to the cent.

c. Obviously, but that is the same for anyone that buys stock, either out right or using put options, what’s your point?

I am not sure you understand put contracts, they are a perfect example of selling insurance, you paragraph about them not being insurance doesn’t make sense at all, when I sell you a put contract, it is indemnifying you against the drop in price of the asset named in the put option contract, I am guaranteeing you I will buy it for a certain price with in a certain time.

6. yes it is the correct word to use, that’s why I used it, because as I said we are dealing In Things that are unknowable and can only be estimated, just because you say you “know” doesn’t mean you do, saying “I think”shows humility not ignorance in fact claiming to know the unknowable is arrogance and ignorance.

7. No, if you go back to the start I was describing earning $X on a certain contract and then multiplying that by 6 to get the annual rate, but then in your example you used that $x figure for 3 months which if you extrapolated that would have given you a wrong annual figure, hence why I said it’s a 2 month contract, but we are last that example now so who cares.

Thanks for the discussion, it has been illuminating.

jog on
duc

 

[wayneL]

@wayneL, you will enjoy this one!

jog on
duc

I remember following that thread at the time, most amusing.

When I have a spare hour I'm going to read back through it, thanks

 

[cutz]

@Value Collector So long as the gamma monster doesn't catch you.

To repeat once again, the same beast that ate LCTM.

But that's off topic, the topic here is *long volatility* as a strategic aspect of a total portfolio.

Long theta/short gamma is a whole 'nuther bowl of wax.

Hi @wayneL , you referring to Long Term Capital Management ? When Genius Failed is one one my favorites reads, I often refer back to it.

FWIW, during my learning phase, ( although must admit I'm always in learning phase ) , I too was a naked equity put seller, quickly came to the realization that when short OTM puts get hit, it's because the underlying fundamentals/trend has shifted, reasons for wanting to be long quickly evaporate.

Anyhow nice thread, thanks for bringing the issue up, haven't got much to contribute but it has led to me to question myself whether I should personally be more aggressive long vol, sacrificing some premium in order to not having to stress out so much...

 

[wayneL]

Hi @wayneL , you referring to Long Term Capital Management ? When Genius Failed is one one my favorites reads, I often refer back to it.

FWIW, during my learning phase, ( although must admit I'm always in learning phase ) , I too was a naked equity put seller, quickly came to the realization that when short OTM puts get hit, it's because the underlying fundamentals/trend has shifted, reasons for wanting to be long quickly evaporate.

Anyhow nice thread, thanks for bringing the issue up, haven't got much to contribute but it has led to me to question myself whether I should personally be more aggressive long vol, sacrificing some premium in order to not having to stress out so much...

Ugh, yes LTCM not LCTM

Anyway, it's like any long investment, try to buy low (Vol) and sell high.

The good thing about volatility is that it is is readily and easily quantifiable via IV/SV, VIX, and other such tools.

The bad part is that patience is required, which attracts me to the Dragon portfolio idea.

 

[Value Collector]

Hi @wayneL , you referring to Long Term Capital Management ? When Genius Failed is one one my favorites reads, I often refer back to it.

FWIW,

I own a copy of that book also.

As an interesting side note to my conversations in this thread, it’s interesting that Duc seemed to think that me not using the Black scholes formula put my portfolio at risk, but the biggest blow up in history “LTCM” was presided over by the creator of the formula.

I believe LTCM failed for two reasons they trusted these short cut formulas to make broad bets without doing individual Manuel evaluations, and they used huge leverage which meant they couldn’t absorb the volatility.

I am not bothered by volatility, I am extremely long term focused, and I keep leverage within limits, so I feel I am set up in a way that by selling naked puts, I can profit by accepting by people who don’t want volatility paying me to put it onto my balance sheet.

 

[wayneL]

I own a copy of that book also.

As an interesting side note to my conversations in this thread, it’s interesting that Duc seemed to think that me not using the Black scholes formula put my portfolio at risk, but the biggest blow up in history “LTCM” was presided over by the creator of the formula.

I believe LTCM failed for two reasons they trusted these short cut formulas to make broad bets without doing individual Manuel evaluations, and they used huge leverage which meant they couldn’t absorb the volatility.

I am not bothered by volatility, I am extremely long term focused, and I keep leverage within limits, so I feel I am set up in a way that by selling naked puts, I can profit by accepting by people who don’t want volatility paying me to put it onto my balance sheet.

That's nice, but still very much off-topic

 

[wayneL]

This is a great podcast discussing long vol with Chris Cole, the author of The allegory of the Hawk and The Serpent, purveyor in chief of long vol as part of a portfolio... With Grant Williams and The Fleck.

It's a great listen whether interested in this or not.

 

[cutz]

This is a great podcast discussing long vol with Chris Cole, the author of The allegory of the Hawk and The Serpent, purveyor in chief of long vol as part of a portfolio... With Grant Williams and The Fleck.

It's a great listen whether interested in this or not.

Nice podcast, sort of confirmed what we already were aware of ( here on ASF ) , the derivatives markets is so large that it influences the underlying market, once it was the other way around, I've been referring to it as back driving, try explaining it to ppl that don't do derivatives, they look at me like I'm nuts !!

 

[InsvestoBoy]

Perhaps I can chime in @wayneL ...since it doesn't really seem like anyone actually bothered to engage with the topic at hand on its merits but rather just talk their book or their d***.

The strategy is not called "The Hawk and the Serpent" it is called the Dragon Portfolio. Allegory being that the dragon tames both hawk and serpent.

I follow Chris Cole closely and his writings, especially the Dragon Portfolio concept since it is an interesting twist on the Permanent Portfolio construct which I use for my own SAA.

The main thing to understand is that this is a global macro portfolio. So you have to give up some expectation of niche specialisation (like investing in individual ASX issues) and go for asset classes under the assumption that each asset class is somewhat efficiently priced within itself. You might be able to move within the asset classes to some degree, and I do as have previously discussed several times on ASF, but by and large you are running a global macro portfolio and returns are dependent on macro regime shifts, not any niche specialisation.

The purpose of this global macro portfolio is akin to the Permanent Portfolio, to "harvest volatility" (https://thepfengineer.com/2016/04/25/rebalancing-with-shannons-demon/) of uncorrelated asset classes that each do well in different macro regimes. Key here being uncorrelated, not negatively correlated. The "twist" being to add two trading strategies and treat the return stream of those strategies as an asset class and subtract cash as an asset class.

Both the trading strategies are actually what you would consider, from a quantitative return profile, as long vol strategies.
* Commodity trend following: using commodity futures only to capture inflation trend, compared to most CTA funds which "diversify" across all futures.
* Long options vol: if you follow Artemis Capital filings etc you will see that their long vol strategy is not something you can replicate easily because it isn't systematic. They are professional options traders looking for options idiosyncracies across asset classes. As just one example, I recall they were long some GC calls in early 2020. It isn't just what most people think of buying puts or other long vol strategies for equities only. They are very tactical and sophisticated on the trades.

The purpose of both of these strategies is to capture macro risks which are not present in the market today and have not been for some decades, but which are believed may eventually return and are completely mispriced today.
* Inflation
* Regime shift from mean reversion (negative autocorrelation in daily returns) to momentum (positive autocorrelation in daily returns) across macro asset classes.
* Changes in interest curves (inflation) which influence options Rho, in the past long options strategies actually carried positive and they may one day again!
* Capture eruptions in vol pricing, this is not always price negative. In commodity space, vol increases are quantitatively associated with price increase quite often. Long vol is not necessarily bearish.
* Take the other side of structural short vol bets from equity buybacks/VaR/risk parity/explicit short vol structured products which currently rule the roost.

If you don't think that simple commodity trend following can be long vol just look at the return profile of http://www.40in20out.com/ as a trendfollowing benchmark.

The point is to get into these "strategies as asset classes" today, even though they have not done well over the last few decades. The goal is not to get into them for profit per se, the goal is to capture their uncorrelated rebalancing volatility (see above link) against macro risks that are not currently present but may return one day.

In the same way as when you enter into a Permanent Portfolio, you have an expectation that some components of that portfolio will do badly while others do well, this is an explicit part of the portfolio construction. You expect drawdowns in whichever asset classes are not expected to perform favorably in whatever the current macro regime is, and actively rebalance into them using profits from the asset classes that are performing favorably in the current macro regime.

Almost nobody in the world (aside from a few PP adherents and even smaller cohort of Dragon Portfolio) are running Constant Mix (https://cssanalytics.wordpress.com/...et-allocation-lessons-from-perold-and-sharpe/) portfolios that have concave payoff profiles today, which adequately hedge against all macro risks that Chris Cole has spoken about and I summarised above. A lottttttt of people are running Constant Mix in the form of 60/40 portfolios but both the assets in that SAA will not do well if Risk Parity shits itself again or inflation picks up. That is Chris' whole point. If you are running 60/40 or Risk Parity, you need to change it up to hedge the future. If you are a niche specialist who thinks nothing macro matters, then none of this is relevant for you at all.

And that concave action is so important to understand in all of this. It's the rebalancing that makes it powerful. Not the exposure to long vol, not the commodity trend, etc. That concave return profile is in a sense long of vol itself, in that it is always on the other side of the trade of structural short vol trades like those mentioned above.

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Personally I haven't switched from PP to DP. The lessons from Hawk/Serpent are different for US investors than AU investors! If you are a US investor running PP on US long bonds, gold, USD and US equities then you are very heavy on deflation trades. AUD holdings and AU equity indices are a different beast (due to sectoral differences) and should be expected to do a lot better in inflation/autocorrelation regimes like we saw 2003-2007 where AUD and Aussie equities just smashed it out of the park. Similar shape up from the March 2020 lows.

So I have kept to the PP but I try and tweak the holdings within the cash and equity asset classes to get some natural exposure to commodity trend (higher weight to AU equities and EM equities) and dynamic changes to USD and AUD allocation within cash because AUD absolutely crushes it on reflation shifts. I also take some discretionary and tactical long options positions and if vols are cheap (not really the case since Feb 2020 when being long vol reaaallly paid) I will put on some equity tails based on https://thefelderreport.com/2016/08...-heres-how-you-can-tail-hedge-your-portfolio/ this strategy.


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Hopefully that is more engaging on the topic you wanted to discuss.