If you ask top traders or money managers to list the most important components to their success, undoubtedly, risk-management would be near the top of the list.  Knowing this, we made risk-management a key focus when designing our VIX Strategies.  Below, we’re going to highlight 8 ways to potentially mitigate risk in volatility trading.

But first, please note a few things:

  • Risk cannot be completely eliminated

  • This is a non-exhaustive list of risk-mitigating methods

  • Our VIX Strategies use a combination of these methods, rather than every method for each particular strategy

1. Keep the Volatility-Risk-Premium (VRP) in Your Favor

All of our strategies seek to harvest the volatility-risk-premium in the VIX futures – this is what provides us with our long-term edge.  At times, the VRP may be positive, negative, or neutral.  The direction of the VRP may provide clues as to the performance of XIV / ZIV / VXX.  For example, backwardation (one potential way to measure the VRP) in the front two VIX futures, tends to correspond to extended drawdowns in XIV.

In turn, our goal is to adjust our positions based on the direction of the VRP, always making sure to keep it in our favor, potentially giving us a long-term advantage.

Note: the VRP cannot be known with absolute precision. We look to the relationship between VIX futures, spot VIX, and realized volatility of the S&P 500 for indications as to the direction/level of the VRP.

 

2. Be Reactive Rather Than Predictive

No one knows the future.  Trying to predict the direction of volatility is a guessing game, and usually a risky one at that.  For example, image the roller-coaster you would’ve gone on trying to time the short-lived and sporadic spikes in VXX this year:

 

Instead of trying to predict movements in volatility, we believe it’s less risky to take a reactive approach – one that reacts to changes in the volatility-risk-premium.  By reacting to changes in the VRP, and always keeping it “on our side”, we can keep the long-term edge in our favor, potentially reducing our risk.

 

3. Strategically Adjust Allocations

Historically (from 2011-2016), a simple scaling in/out strategy (although not advisable) greatly outperforms an XIV buy and hold approach.

Below are the results of following a simple process of increasing exposure to XIV as the level of drawdown increases, and adjusting that exposure back to the base-level once the drawdown in XIV is eliminated.

While this exact scaling strategy is not advisable for most people (max drawdown is over 50%, and the strategy is often working against the VRP), it may be possible to reduce drawdowns (i.e. lower risk) by adjusting allocations based on the current level of drawdown in XIV.

For this reason, most of our strategies use some sort of mechanism to strategically alter allocations (while also keeping the VRP in our favor) based on drawdown levels.

 

4. Eliminate Overnight Positions

XIV has a termination event clause that states it will be terminated if it experiences a daily loss greater than 80%.  Many investors are fearful of this potential event, especially with the VIX currently trading near the low end of its historical range.  It could be argued that, if this event were to occur, it would most likely be caused by a large, adverse overnight event.  One way to greatly reduce this risk is to simply avoid taking overnight positions.  Consequently, 3 of our 6 strategies are intraday strategies that avoid taking overnight risk.

Note: to make up for the fact that our intraday strategies do not capture favorable overnight moves, they may employ intraday leverage – essentially leveraging the open-to-close return, while avoiding overnight risk.

 

5. Utilize Intraday Stop-Losses

Generally, incorporating stop-losses into a trading strategy makes performance worse.  This is no exception for volatility strategies.  We do not utilize stop-losses in the traditional sense, however (ex: cutting a position at the point at which the trade is “wrong”).  Instead, we use them as a “backstop” to protect us against extreme adverse intraday price moves.  For example, if there was some sort of large intraday “flash crash”, or perhaps a large geopolitical event, the stop-loss would be expected to provide a backstop against uncontrolled loss.

Note: we only apply this method to our intraday strategies.    

 

6. Be Systematic

Every time you have to make a decision, you open yourself up to making a mistake.  Having a systematic, or rules-based approach, reduces the emotional and human elements of trading, possibly eliminating a large risk factor.

 

7. Maintain a Long-term Perspective

By their nature, volatility strategies tend to be volatile, and drawdowns are inevitable from time-to-time.  If you’re not prepared (both mentally and financially) to stick to a strategy for the long-term, you risk getting shaken out at the worst possible time – during a drawdown.  While we seek to reduce the magnitude and duration of drawdowns, we accept that they will occasionally occur.  In turn, we’re prepared for them to happen, and are fully committed to our strategies for the long-term – likely increasing our chances for success.

 

8. Diversification

Not all VIX strategies are exposed to the same risks, and each has its own set of strengths and weaknesses, leading to outperformance/underperformance across varying market environments.  In turn, diversifying across strategies may help balance out various risk factors, possibly reducing drawdowns.

There are numerous factors you can diversify across.  Here are the ones we focus on:

  • Trade Structure

Some strategies hold overnights positions (swing strategies), while others are intraday only – balancing out overnight risk.

  • Term Structure

Different strategies may be exposed to different parts of the VIX futures curve (ex. mid-term VIX futures versus short-term VIX futures) – balancing out risk-reward.

  • Signals

While all of our strategies seek to harvest the VRP, the “signal” to determine the direction and level of the VRP may be different.  For example, some strategies may focus on the slop of the VIX futures curve, while others may focus on the spread between the futures and spot VIX, or the spread between expected and realized volatility.

  • Scaling / Allocation

Different strategies have different levels of exposure to their positions at various times, taking advantage of current drawdown levels to varying degrees.

 

Further, there may be advantages to diversifying across volatility strategists.  This is the approach that Invest In Vol – The Volatility Advisor advocates.  Invest In Vol is the first Registered Investment Advisor to offer the diversification of three leading volatility strategists in one managed account.  By combining three distinct strategies – each concentrating on different factors – Invest In Vol seeks to dampen drawdowns, and deliver more consistent returns to your portfolio.

 

Summary

We hope this post helps shed light on our methods for mitigating risk in VIX strategies.  We’d love to hear your preferred methods for mitigating risk – please leave a comment below, or reach out to us on Twitter with your insights.