I have an equity long/short strategy that works well, but the numbers tend to get weaker whenever there is a sudden burst in volatility. I've done the analysis on 3-4 years of data, and the evidence is statistically significant that volatility bursts associated with one direction in the market are just not my friends. Is the correct way to hedge my risk during vol bursts to buy the VXX/VXZ etf, or is there a better way? Would I look at my "basket" (portfolio) and purchase some sort of combination of options to reflect the volatility of my basket? Or, alternatively, should I take some crude vol-forecasting model and incorporate it into my portfolio? It isn't just the level of the VIX that is the issue, so much as short term shifts in the VIX and evaporation of liquidity that sends me to the poor house. Timing the hedge could also be a problem; seems like smoothing out my equity curve would be easier to do if I stepped aside and went long the VIX. Has anyone worked around this problem? Is it worth my while to work around this issue with a hedge to keep performance satisfactory, or should I just sort of hibernate and wait for vol to revert to some local mean?
Oh, I should add that I'm not managing millions. I'm just a low capital, tens-of-thousands-of-dollars retail bozo whose idea of a great deal is getting extra pancakes at the IHOP in the ghetto. I'm mentioning this because for the size I manage, there's no market impact and getting in and out is easy; therefore, the cost of a hedge may be inappropriate. I'm just too inexperienced to know whether I'm going down the right path.
VXX may work if you are good at anticipating short-term volatility spikes and limit your hold time to a few days. VXX has a lot of decay built in: e.g. over the last 10months VIX lost 40%, VXX lost 80% :eek:
Is it merely downside volatility, or both upside and downside? Typically, you get a skew in equity options because they "crash down," whereas commodities "crash up." Are you getting liquidity issues on both the up and down sides?
It's just whenever there's a sharp, sustained move to one side or the other, and when the "usual" way of doing business is interrupted. Like when a stock or set of stocks goes parabolic, either up or down. There aren't very many cases of this, but when it happens, it makes for a loss or low-profit month. Right now I am trying to diversify to avoid this, but since all the instruments are somewhat correlated, you can see the losing trades positive correlation with spikes in the VIX.
Well, the portfolio is beta neutral, or tries to be. Sharp sustained moves against me are usually news driven, where assumptions about beta-neutrality break apart. Many times this is attributable to differences in liquidity in products that are beta-neutral during the "status quo", if that makes any sense.
sounds like at certain times the risk events all become highly correlated. This is common with most long short trading, remember Aug. 2007? I would look into some kind of macro overlay to generate a better marketwide view of risks in the market. one sector analysis (specific stocks/sectors with volatility higher than normal) volume changes, etc... Perhaps you can combine the overlay into a signal that better positions your strategy to be in cash or some long volatility asset (spreads, vol, fx vol) I haven't been able to code this idea myself, but why not take a statistical view of your strategy -if the returns/volatility/liquidity constraints are being violated, you unwind the trades and jump into the long volatility assets...
I guess I can look at the time-series of returns on VXX, assume volatility persists, shut down the equity long/short, and put on a long on VXX during dead periods. But this gets back to my original question -- do I now go down the path of forecasting volatility for hedging purposes, using a generic instrument like VXX, or take the composition of my basket and go long through some basket of options? I'm leaning towards VXX for simplicity, and because I don't need to maintain an options account for it. I'm open to other ideas on how to smooth out my equity curve with regard to volatility, though.
volatility is a measure of how liquid the Market is as well as fundamentally how uncertain the directional bias is. Its hard to analyze liquidity nowadays in equities (maybe in other futures too) because HFT distorts it - See Joe Saluzzi's articles. You could look into how basis traders blew out in 2008 (big banks and hedge funds got killed, but were bailed out and continue to function today though likely with much less access to leverage - though with the 0 rates, their leverage might be back to where it was in 2007) So that aside, designing a strategy that accommodates / derives an edge from estimating or reacting to volatility is hard to do, because these basis guys couldn't do it either. You would want to switch out of a directional strategy into a long volatility strategy or hedging strategy which might involve index options, options on equities, or hedging with index futures. The problem is everyone is doing this at the same time and it distorts the Market. What interests me is an idea of how risk events propagate through the Market... say a few weeks before a correction you'll see unusual moves in one sector, and then the Market calms down a bit before a big move up or down... but its hard to measure and relate one sector move into an anticipatory tool for your portfolio risk and have the signal enabled to specifically react to your individual trades in the optimal way.