Variations of Volatility
In the last entry I showed that adding volatility to a typical equity/bond portfolio makes it better. Feel free to define better however you like (lower volatility, higher Sharpe ratio, lower drawdowns…): a volatility position makes things better.
But the example I gave understates the case. There are several ways to trade volatility and they aren’t as correlated as people think. So instead of just adding one type of volatility we should add two.
The first way is to trade implied volatility. This can be done by trading VIX futures, VSTOXX futures and the various volatility ETNs. This was the example I used previously. In Figure One I show the results of buying XIV (the VelocityShares Daily Inverse VIX Short Term ETN) in 2016.
Figure One: The growth of $100 when buying XIV.
Maximum drawdown: 38%
Sharpe Ratio: 1.3
The other way to get volatility exposure is to trade realized volatility by trading equity options and hedging appropriately. The details of how to do this aren’t trivial and are dealt with in my book, “Volatility Trading”, but it is also possible to do this profitably. In Figure Two I show the results of selling and hedging SPX options in 2016 (according to one of Talton’s proprietary strategies).
Figure Two: The growth of $100 when dynamically hedging SPX options.
Maximum drawdown: 9.4%
Sharpe Ratio: 2.2
Obviously, the effective leverage of XIV was higher. But far more importantly is to notice that their daily correlation is only 54%. By way of comparison the correlation between MSFT and AAPL (to randomly pick a couple of somewhat related mega-cap stocks) was 50%.
You wouldn’t just put one stock in a portfolio. You shouldn’t just put one type of volatility in either.