Inverse of volatility decay investing, a long term theorycraft.

Discussion in 'ETFs' started by Terikan, Oct 18, 2013.

  1. Terikan


    If you are like me, then you have compared charts of etf's where one side of a pair takes the short side, and the other the long side. Or what happens after a long enough period on a non-leveraged etf and a 2x or 3x.

    It never really occured to me, no matter how many times I saw how the loser in the pair trade, after a long enough period, would get to about 90% loss and stall out. Obviously it could never lose more than 100%

    However, the 'winner' of the pair trade, after long enough, surpasses 100% in gains.

    Meaning if you start with the same funding for both, you will lose in the short/med term with volatility decay. However, eventually this 'should' turn.

    For example, say you are long XIV and long VXX. You lose a little at first, but after a couple years you are likely up 200% in XIV, and down 95% or so in VXX.

    When you trade to capture volatility decay, you have to rebalance to prevent this from happening, so it occurs to me, why not have a longer term plan where you do not rebalance, just hold.

    You can also do this with VXX vs UVXY, theoretically of course (based on backtesting so no garauntees of future behavior). If you start with say a 20k short on VXX, and a 10k long on UVXY, they will move together, but the nature of this beast is that they fall towards zero over time. You are buying insurance when you are long these, and that has the price of being unsuitable long-term.

    So take the example above. After 1 year VXX is down 60%, UVXY is down 90%. Your P/L stayed about the same for 6 months, then it would have started to work in your favor. You end up making 12k on the VXX short, and losing 9k on the UVXY long.

    One benefit to a strat like this instead of shorting UVXY outright is of course much lower risk in the short/med term. And leveraged ETFs do on occasion out perform if their underlying is trending strongly in one direction. So even if the VIX was trending up steadily for a while (which it doesn't do so this is probably pointless conjecture) you may still come out ahead by a small amount.

    But more than likely you will lose until UVXY has lost over 70% and VXX 35%

    I'm interested in thoughts concerning these ideas, and if anyone thinks it's feasible in the future and isn't just a fluke of the long bull market we've had.
  2. newwurldmn


    it means that your risk is changing. You are getting shorter vol as time progresses.

    You might as well wait 6 months and then just short the VXX rather than putting a hedged position now.

    The vol spike risk is the same in both.
  3. zdreg


    "You might as well wait 6 months and then just short the VXX rather than putting a hedged position now."
    the statement has an obvious error in logic. it has some similarities to the surprise test paradox.
  4. newwurldmn


    What error is that?
  5. newwurldmn


    I did. It doesn't apply here.
  6. zdreg


    the OP or anyone else who checks it out will most likely come to a different opinion.
  7. Terikan


    I concede when examined closely there's little difference. I should have scrutinized it a bit more.

    It could remain a strategy for people who want to put on large positions now with less immediate risk, rather than smaller positions some time in the future.

  8. newwurldmn


    A lot of options strategies can be simplified down.

    Its easy to make them complicated.

    It took me years to figure that out.