Monday, March 20, 2017

How do we short Volatility?

I intended this blog for people who are already in the options/VIX space and are sick of it all, and looking for more qualitative rather than quantitative discussion. However, for the new traders or general thespians who are early in the market journey, I thought I'd add a small short vol primer.

The main instruments of short vol:
Buying VIX puts (expensive)
Selling VIX calls
Holding inverse products - buying XIV , SVXY
Shorting long VIX products- short VXX, UVXY, TVIX
Options on these ETFS- Selling UVXY calls, selling SVXY puts

Sixfigureinvesting has incredibly detailed articles on all VIX products

That site really gets under the hood and is something I would recommend reading the whole way through to get familiar with the mechanics of those products.  I didn't simply want to regurgitate other site's overviews here.

In the current historic low volatility, I lean toward selling SVXY puts.  This keeps a guaranteed premium coming in, whereas holding XIV or SVXY could stay choppy to flat. I prefer this to selling VIX calls because any short position like that has the unlimited upside risk, as well as it being cash settled so I can't be assigned SVXY and then start selling calls against it.
 Furthermore, I think SVXY gives a smoother long term slope in comparison with shorting TVIX/UVXY , which have a 2x leverage, as well as associated borrowing costs. Finally shorting any instrument takes on the unlimited upside risk which could be theoretically more dangerous than SVXY going to zero.

When investing in long or short volatility products, I think an incredibly important factor is to keep a large portion of the portfolio in cash, which is a big distinction from the buy and hold, "no dry powder" school.  Cash is a position, I just think many short vol traders overdo it, for example right now at record low VIX I see a lot of short vol traders 100% in cash. 

Part of this blog is trading psychology and even if periods of 100% cash are backtested to be optimal, as a human I don't think I can go there because you really are in the unknown.  Sooner and sooner you will be tearing your hair out watching the market stay flat or up, as it does over time.  At the minimum I would want to keep some amount of short SVXY puts to keep the premium coming in during absolutely flat/ all time high markets, although I would keep over 50% of the portfolio in cash.

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