Long-Dated Volatility Trade

May 6, 2011
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Why don’t long only investors hedge their gains, especially in extreme environments like these?

It’s a rhetorical question, really. The answers are more or less known (not their cup of tea etc).

But from a practical, pragmatic standpoint, it still seems odd. Most any investor will buy home insurance and car insurance — and in fact would feel quite exposed without either.

And yet, as far as market exposure goes for a sizable retirement portfolio — with a possible value many multiples of the house and car combined — no insurance and no thought of it. Go figure.

Below is an example of recent commentary from the Mercenary Live Feed. It’s a sneak peek at our “thesis notes” on a Long-Dated Volatility Trade — the type of position with minimal implementation costs that could nicely hedge a portfolio. (Or provide an opportunity for attractive speculative gain with 100% limited risk.)

If you like what you see — and would like to see the details of the actual structured options position — note the free trial link at the end of this post.

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Thesis Notes: Long-Dated Volatility Trade

7:47 am – May 4, 2011

Notes on long-dated volatility trade, expressed through a “set and forget” structured options position of 4 to 6 months duration (below the jump).

Markets are currently in an extreme state. Spurred on by record corporate profit margins, easy money from the Federal Reserve, and a sense of euphoric invincibility, investors have pushed markets to dangerous heights.

John Hussman has an excellent recap of current conditions in his weekly commentary, Extreme Conditions and Typical Outcomes.

The following is Hussman’s answer to the question, “When conditions were as statistically extreme in the past as they are today, what was the result?”

The foregoing set of conditions isn’t observed often, but the historical instances satisfying these criteria in post-war data are instructive. Here an exhaustive list of them:

August 1972, November-December 1972: The S&P 500 quickly retreated about 5% from its August peak, then advanced again into to its bull market peak near year-end (about 6% above the August peak). The Dow then toppled -12.3% over the next 50 trading days, and collapsed to half its value over the following 22 months.

August 1987: The market advanced about 6% from its initial signal into late August. The S&P 500 then lost a third of its value within 8 weeks.

June 1997: The only mixed outcome, during the strongest segment of the late 1990′s tech bubble. The S&P 500 advanced another 10% over the following 8 weeks, surrendered 4%, followed with a strong advance for several months, surrendered it during the 1998 Asian crisis, and then reasserted the bubble advance. Over a 5-year period, the overvaluation ultimately took its toll, as the the S&P 500 would eventually trade 10% below its June 1997 level by the end of the 2000-2002 bear market. Still, the emergence of the internet, booming capital spending, strong economic growth and job creation, rapidly falling inflation, and dot-com enthusiasm evidently combined to overwhelm the negative short- and intermediate-term implications of this signal.

July 1999: The S&P 500 advanced by 3% over the next two weeks, then declined by about 12% through mid-October, and after a recovery to the March 2000 bull market high, the S&P 500 fell far below its July 1999 level by 2002.

March 2000: The peak of the bubble – the S&P 500 lost 11% over the following three weeks, recovered much of that initial loss by September, and then lost half its value by October 2002.

May/June 2007, July 2007: The S&P 500 gained 1% from the late-May/early-June signal to the July signal, then lost about 10% through August 2007, recovered to a marginal new high of 1565.15 by October (about 1% beyond the August peak), and then lost well over half of its value into the March 2009 low.

February 2011, April 2011: A cluster of signals in the 2-week period between February 8-22 immediately followed by a decline of about 7% over the next 3 weeks. As of Friday, the market has recovered to a marginal new high about 1.5% above the February peak.

So not including the cluster of signals we’ve observed in recent months, we’ve seen 6 clusters of instances in post-war data (we’re taking the 1997, 1999 and 2000 cases as separate events since they were more than a few months apart). Four of them closely preceded the four worst market losses in post-war data, one was quickly followed by a 12% market decline, and one was a false signal over the short- and intermediate-term, yet the S&P 500 was still trading at a lower level 5 years later.


The bottom line: Extreme market conditions, of the type that exist now, have the tendency to resolve with sharp, violent declines. Complacency is a killer, especially when danger signs are mounting.

At the same time, it is hard to fight a bullish tide. The tricky nature of such conditions is as follows:

  • A relentless rise and a sense that markets can “do no wrong.”
  • Dip after dip resolving to the upside, as fresh buys support the market.
  • A general exhaustion of patience and resolve on the part of bears.
  • A jarring, violent shock that comes out of nowhere — catching the majority of market participants completely by surprise.

It is possible to identify market conditions when this scenario is present. But it is hard to capture gains from such a scenario with standard swing trading methodologies. That is because of the binary nature of the shift — from rising trend, like the rising face of the cliff, to a sudden violent drop in a very tight space of time.

For the above reasons, we like the idea of a long-dated volatility trade, put on in the form of a structured options position. Here is what that means:

  • A trade constructed with options where maximum risk is 100% defined. (Total risk is 100% known at the time of putting on the trade.)
  • A trade that is “set and forget” over an extended time period — say, four to six months time.
  • A trade that will book large gains if the markets experience any type of severe shock: From a new “flash crash,” to a new top down disruption event, to an ’87 or ’94 or 2000 style crash and so on.
  • A trade that cannot be stopped out, with risk limits impervious to, say, a continued rise in risk assets before the high volatility event occurs.
  • A trade that is low cost to put on (in terms of margin) and does not require heavy investment in option time premium.
  • A trade that does not need a “crash” to break even — but instead can do well (or at least not lose money) if the market declines modestly rather than crashing.

The advantage of a position like the above?  The ability to sleep at night knowing any “crash” out of the blue will represent a captured opportunity — if the markets open with a bloodbath on a random Monday morning, the play is in place.

We are currently working on different combos for structured options positions — a combination of puts and calls — that are “set and forget” and meet the trade criteria as described above. As of now we are looking at two positions, both designed to take advantage of a major market dislocation / massive volatility spike, in the following instruments over the next 4 to 6 months:

  • SPY (S&P 500 ETF)
  • UUP (ProShares Dollar Bullish ETF)

More details on trade construction and execution shortly forthcoming.

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Again, the above commentary is a ‘sneak peek’ at the type of analysis made available to members, in real time, via the Mercenary Live Feed.

If you would like to see the actual details of the structured options position — which we implemented earlier this week at a net credit, with limited risk — you can do so by taking a free test drive and experiencing the Live Feed for yourself.

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2 Responses to Long-Dated Volatility Trade

  1. syoung on May 7, 2011 at 11:18 am

    as far as "mom and pop" retail investors, many of them likely dont buy portfolio "insurance", because they dont acknowledge the need, and neither they nor their financial planners have the requisite skill to devise appropriate insurance. I cant speak for the US, but in Canada most financial planners are MFDA registered which means they are licensed to sell mutual funds. Stocks, ETFs, options etc., would be covered by a more expensive certification; so most financial planners would not be licenced to provide this insurance even if they knew it existed. The other issue is that average financial planners have a very simplistic investing model where you essentially put a bit of money into a number of pots (stocks via mutual funds, bonds via bond funds etc.) and just add to it ("dollar cost averaging") and ignore it ("buy, hold, and prosper", "stay the course", "no one could have seen "2008/Lehman" coming" etc.) ; and of course this model is completely against market timing (they even deny it can be done). So in their mind the ups and downs of the market are unpredictable and must be accepted, and that proper diversification (mix of stocks/bonds etc) is the solution.

    At the end of the day insurance only makes sense if not having it would be catastrophic, and if one can purchase appropriate insurance where the cost benefit makes sense. For many/most planners/retail investors this cost/benefit analysis is beyond their skill level (even if they acknowledged the need).

    • Jack Sparrow on May 7, 2011 at 11:31 am

      Well stated, and agreed — the world of risk management is wholly alien to most investors (and most advisors too), as are the concepts of going to cash, generating alpha, taking concentrated directional risk, and so on.

      As Julian Robertson says, "Not a whole lot of people are equipped to pull the trigger." The broad industry response to that truth is cultivating the mythology that trigger-pulling has no value.

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