What You Need In a Crisis - A Strategy That Feeds on Fear
Many investors are long-term stock pickers. And enduring a market crisis can be a painful process especially if they already have a sizable amount in the market and are not looking to add on to the risk. The best scenario they can hope for is for their picks to hold up better and recover faster than the rest while they tide through the downturn. Now, mitigating losses is important but it is not the only way to navigate a crisis. In fact, you can try to make some money out of a crisis although it is an order of magnitude more difficult than the former. In this post, we will talk about one such strategy which we use in our multi-strategy model. Based on model performance since 2006, it delivers more than 20% per year and outperforms significantly during crisis periods.
Common Ways to Make Money During A Crisis
There are many different ways we can make money during a market crisis. For example, you can short the market outright, buy an inverse ETF, purchase puts, or shift your money into safe havens. But, of course, none are guaranteed and all have their own drawbacks.
Shorting comes with the potential to lose more than your invested capital besides added financing costs and the risk of margin calls. With inverse ETFs, you bear additional fund expenses and it may not track exactly the inverse performance of the market. Puts, on the other hand, are complex instruments that are influenced by a host of different factors, have a time to expiry, and can be expensive. Finally, safe havens such as Treasuries and Gold, which we believe should form a part of a well-balanced portfolio, will not work well in certain regimes. We have seen what happened in 2022 when inflation drives almost every asset class down.
So are there alternative ways?
Volatility Trading - Our Way of Making Money In A Crisis
We can trade Volatility. It has a different profile from traditional asset classes that fits our purpose well. However retail investors tend to shy away from volatility because they are not familiar with it. The interesting thing is among this group, some may already be trading options. I may be wrong but there is a good chance they are unaware that when they trade options, they are actually also trading volatility. Because volatility is one of the key components that are used to price an option.
Without delving into the specifics, volatility is a measure of uncertainty in the market. It is also used as a fear gauge. When volatility is high, fear in the market is perceived to be high and when volatility is low, fear is deemed to be low. At the moment, only the US market has liquid exchange-traded volatility products such as futures and ETFs that retail investors can readily access. These products are all based on the VIX Index. With appropriate strategies, we can use these products to profit off fear and greed which is ever present in the financial market.
The Unique Properties of Volatility
1️⃣ The movement of VIX is low to negatively correlated with all other traditional asset classes.
This is one of the most sought-after properties. Because it allows you to create another profit stream that is uncorrelated with others thereby reducing your risk and dependency on other asset classes to perform. This can make your overall portfolio much more resilient. And that is why institutional investors spend a good amount of their resources hunting for and researching such strategies.
2️⃣ The price of VIX-based products such as futures or ETFs decay over time.
Most of the time the futures term structure of VIX is in contango. This means long-dated VIX futures contracts are priced higher than short-dated contracts which are in turn higher than spot VIX. This means that if all other conditions stay the same as time passes, these futures will lose value as they approach their respective maturity dates. Hence, volatility products such as ETFs structured using VIX futures also have this built-in decay. This decay can work in your favor when you are on the short side of the trade.
3️⃣ Volatility rises much faster in times of fear.
VIX surges in times of fear and it does not matter what is driving that fear. It can be the collapse of the real estate market. It can be a massive debt fallout. It can be a severe liquidity crunch. It can be war. It can be a crisis of confidence. It can be unexpected runaway inflation or the US central bank hiking rates at an unprecedented speed. As long as fear and uncertainty rise, so does VIX. And therein lies the potential to capture outsized profits in a short span of time when a crisis comes.
Just like a stock, volatility can be underpriced or overpriced. So, the underlying strategy is simple. You buy volatility when it is underpriced and you short it if it is overpriced. When volatility is underpriced, we can see it as an indication that the market is more complacent (less fearful) than it should be. And if volatility is overpriced, then the market is deemed to be more fearful than it should be.
VIX-based products are volatile. Their day-to-day moves can be huge so sizing up the trades is important. Because not every trade makes you money. There will be losing trades. And you don’t want to be caught on the wrong side when you have a large position on it. Besides sizing, we also implement advanced rules and monitor market developments for signs of increased tail risk on the volatility trades. Tail risks are events that might result in extraordinary losses. And when a warning flag is triggered, the trades are sized down or completely exited until the coast is clear again.
The Model Outperforms a Buy-And-Hold on SPY from 2006 - 2023
From September 2006 to August 2023, the Advanced Volatility Trading Model outperformed a buy-and-hold on SPY (S&P 500 ETF with dividends reinvested) across all aspects. It delivers a higher CAGR using a lower amount of risk and experiences a lower maximum drawdown during the period.
Note: Transaction costs for trade executions such as commissions and slippages are factored into the model.
Advanced Volatility Trading Model Delivers in Both Calm And Crisis
The Advanced Volatility Trading Model is not just a strategy for crises, it also performs when markets are bullish. It shorts volatility when times are calm where it profits from falling volatility as well as the decay we talked about earlier. Then in times of crisis, it can potentially turn long to capture the spike in volatility as fear surges.
One of the main appeals of this strategy is its potential to profit during a major crisis. It did well during the 2008 Great Financial Crisis, and 2018 Volmageddon, as well as during the rapid 2020 Covid selloff. And even if it fails to eke out any profits, its performance during other crises is still far better than a buy-and-hold in SPY.
Post Crisis Performance
And like what was mentioned earlier, being able to perform in a crisis does not mean it can't deliver in good times. While on average, it trails behind the S&P 500 in performance post-crisis, it still produces a positive return over time.
Why do we run Advanced Volatility Trading as part of our Multi-Strategy Model and not on a standalone basis?
This is a question we often get. The reason is twofold:
1️⃣ By selecting and running low-to-uncorrelated strategies that complement one another in a portfolio, we can reduce the risk significantly and produce a much more stable return profile that allows one to grow their wealth steadily.
2️⃣ We want to mitigate the risk of any single strategy in our portfolio. All strategies have their own weaknesses and will eventually run into their bad patches. On a standalone basis, some strategies bear a higher level of risk and have a greater propensity for tail risks. Volatility trading strategies belong to this class.
Any historical performance we see is always a function of how a strategy has done in the past whether this is live, backtested, or forward run. It shows you what has happened and not what will or can happen in the future. While statistics and numbers are critical in helping you gain insights and confidence into the strategy, they cannot capture everything. A certain level of understanding behind the strategies is still required to assess risks that are not reflected.
As an example, everyone can create a very smooth and steady return profile just by selling naked out-of-the-money options. Because as long as no major event happens, we can keep collecting option premiums. So month on month, we will register profits. If we are lucky, that can last for a while. However, indiscriminate options selling without proper strategies to manage the downsides is a firm recipe for disaster. Because all can be taken out in a single day when the market moves drastically against us. These are risks you would not be able to tell from numbers alone until the event occurs. But an understanding of the underlying strategy would have alerted you to it.
Note: This model performance uses more advanced strategies than those taught in our courses. Note that live performance may vary due to execution price slippages, the difference in sizing precisions, etc. All performances are measured in USD terms.
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AllQuant uses the advanced volatility trading strategy in the multi-strategy model, capital-protected income model, and capital-protected growth model. These are developed with 30 years of joint experience across asset management, banking, proprietary trading, and hedge funds.
You can now build these portfolios through iFAST Global Markets without lifting a finger. In this collaboration, we are combining AllQuant’s expertise in hedge fund strategies and iFAST’s advisory capabilities and bringing it to your doorstep.
If you are interested in finding out more? Chat with us over a cup of coffee through a session facilitated by iFAST Senior Investment Adviser, Ou Da Wei, to find out more.
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