In this Module we look at options and how you can use them to protect a portfolio against extreme, unpredictable events.

We also discuss the dynamics of equity volatility and present a systematic strategy for trading VIX derivatives. We finish the module with a discussion of the unique opportunities that present themselves in times of extreme market stress.

One of the challenges of active trading is that:

• The best opportunities tend to occur in the eye of the storm, when normal market relationships are stretched
• But that’s usually after a significant drawdown in most effective strategies.

So, if you’re not careful, you can end up in a situation where you have the least buying power just when you want it the most.

Options have useful properties to help us try to navigate this. We might choose to “pay up” for protection against a market crash, to cushion drawdowns, and ensure that we have the capital we need to take advantage of opportunities in the chaos.

We’ll look at very simple tail-hedging techniques.

Next, we look at a time-varying volatility risk premium harvesting strategy in VIX derivatives.

Previously, you learned about Risk Premia Harvesting. You learned that you tended to make excess returns over the long haul for taking on certain risks.

We didn’t try to “time” our exposure to the “risk premia’ in because:

• These premia appear to be very large
• Every time we are not exposed to them we “miss out” on the premia
• There’s a lot of evidence that timing our allocation to risk assets is hard
• We didn’t want to screw up a “stonkingly obvious high-probability edge” by overcomplicating it.

However, there is some evidence that some risks are not rewarded all the time.

In fact, there’s evidence that taking on some risks can sometimes appear to be quite a bad idea. A good example of this is what we call the Volatility Risk Premium.

On average, equity index options look to be slightly too expensive. It is easy to understand why.

An effective way to “insure” a portfolio of risk assets is to buy options that pay off large in bad times.

“Selling volatility” (using equity index options or VIX products) tends to receive a risk premium because it tends to incur large losses in market crashes.

But there’s evidence that it’s a bad bet to take on that risk all the time.

In fact, due to very lopsided customer positioning, going long volatility tactically can be an excellent trade at times.

We’ll walk through this dynamic and describe a simple trading strategy to exploit these effects using VIX ETPs or VIX futures.

We’ll investigate the time-series properties of VIX. And you’ll note that it’s easy to predict:

• It tends to cluster (stay the same in the short term)
• It tends to revert to its mean over the longer term
• It is positively skewed
• It tends to have a floor under which it won’t go lower
• It tends to increase when the equity index declines
• It tends to show conditional trend effects.

It is not surprising that VIX is predictable, because you can’t trade VIX.

So there is no competitive mechanism to drive out inefficiency.

So we’ll look at VX futures and observe significant basis effects in the futures prices. If VIX is very low, the futures will tend to trade higher than the index. If VIX is very high, the futures will tend to trade lower than the index.

Why?

Because everyone knows volatility is likely to revert from extreme values.

So you won’t find anyone prepared to sell you VIX futures at 9% when VIX is at 9%. The sellers will demand a premium and the buyers will be happy to pay – because everyone knows VIX is more likely to go up.

The futures contracts tend to “price in” the obvious, predictable changes in volatility.

Trading VIX products is not as simple as “predicting VIX!”

You’ll model the “basis” as made up of two elements:

• Predictable future expected changes in volatility.
• The left-over stuff that’s not explained by that – which we call a “time-varying risk premium”.

This leads to a simple systematic strategy to exploit the time-varying volatility risk premium.

This is the most untamed of the strategies we explore in any of the courses. So we’ll have a robust discussion about skew, risk, and sizing.