We’ve all heard of the “cut your losses early” and the “let your winner’s run” (and many, many more) trading axioms that apply to trading in general. But what characteristics give you an edge specifically in volatility trading? Below are 5 Key Characteristics that we believe lead to successful volatility trading – all of which we apply in trading our strategies.
1) React Rather Than Predict
No one knows the future, yet so many traders stress over things like the future direction of spot VIX, or where stocks will be a month from now, etc. Great volatility traders know you don’t need to know those things to make money.
We like to focus on things we can control. Since we can’t control the future, we put zero effort into prediction. This includes predictions about the direction of stocks, when volatility will spike, or price targets on the ETNs/ETFs we trade. Instead, we focus all of our effort on putting the known risk-premiums/spreads (Roll-Yield and/or VRP) in our favor at all times, and reacting to changes in those premiums.
There is no guessing what the premiums are – they are determined by market pricing – and simply are what they are. This removes the stress of feeling like you constantly have to be one step ahead of the market, or feeling like you have to know the unknowable.
2) Always Have the Risk-Premiums in Your Favor
Following up #1 above, if you have no edge in predicting the future, you must gain an edge from somewhere else. We believe the best way to do this is by always having risk-premiums in your favor. Specifically, we target the Roll-Yield and/or VRP (note: there are numerous ways you can measure these premiums). Since this is where our edge comes from, this is where we focus our attention, and we make sure we’re always “on the right side” of the premiums.
Example: This could mean staying short volatility because the VIX futures curve is steep relative to spot VIX (a reaction to the Roll-Yield), despite spot VIX being at the low end of its historical range and despite you suspecting an eventual spike in spot VIX (a prediction about the timing and direction of spot VIX).
3) Long-Term Mentality
It’s been shown that, over the short-term, price fluctuations of volatility ETNs/ETFs (ex. VXX and XIV) are mostly driven by changes in spot VIX. Over the long-term, however, price is mostly driven by the risk-premiums.
Thus, if your edge comes from always having the risk-premiums on your side, rather than from catching short-term moves in volatility (again, a reaction rather than a prediction), then you need to earn those premiums over a long period of time to offset short-term movements that go against you.
Matt Thompson, CFA (@dynamicvol) said it best – “Spot wins the battle, curve wins the war”. We’re not looking to fight battles against the curve (VIX futures curve) – we’re looking to win the war with the curve in our favor. This is why we maintain a long-term (multi-year) perspective when trading volatility. To think of it another way, we’re lining up the time period of our edge with the time period of our strategy.
4) Willingness to Sit Through Drawdowns
If you have a long-term focus, and accept that you’re not going to try and time short-term movements (i.e. not make predictions), you inevitably will face short-term drawdowns. This becomes a problem only if you’re not prepared both mentally and financially for such drawdowns to occur. If you accept that short-term drawdown will occur, and account for them in your process, it frees you to capture your edge (in our case the risk-premiums) over the long-term – leading to long-term profitability.
This is arguably the hardest aspect of volatility trading, and what we believe leads to most volatility traders failing. In turn, however, the fact that most people aren’t willing to sit through short-term drawdowns opens up the opportunity for those who maintain a long-term perspective.
5) Low Human Intervention
If you have a strategy and process that gives you a long-term edge, you need to ‘get out of your own way’ and allow yourself to capture that edge. You have to remove all emotions of fear and greed – you have to resist the urge to abandon your process during an inevitable drawdown, and you have to give up the desire to “outsmart” the risk-premiums over the short-term because you think you can “do even better”.
The only times we have overridden our strategy is when we’ve faced large binary events that we believe offer poor risk/reward and no edge (the highly controversial US election was one such case). Our results when we do override our strategy, however, are usually worse than if we would have just stuck to our long-term edge.
While we believe the 5 characteristics above are all very important, it is a non-exhaustive list. We’d love to hear what has led to your success in trading volatility – please leave a comment below, or reach out to us on Twitter with your insights.