Adopting Correction and Harnessing Volatility

As the markets continue to make new highs, I started noticing a distinct chatter in our subscriber only facebook group about imminent correction and how to protect your portfolios from it. The concern is valid and corrections do happen. At the same time the trades resulting from the paranoia of looming correction actually ends up wealth destructing in long term. These go against the thesis of long term investing principles we follow at MoneyWiseSmart. Our view of managing corrections is described in this video.

Internet is filled with get rich quick furus who would be constantly talking about shorting the markets, buying ridiculously out of money puts (since they are cheap and fit into a $1 put thumb rules), or getting long VIX via various strategies. Let us look at them one by one if these really help your portfolio in long term repeatedly and consistently.

Think long term.

Ask yourself who you are? Do you try to benefit from if implied volatility (IV) spikes up or do you try to take advantage when IV spikes up? Here lies a key fundamental difference in thinking and positioning.

No one know the answer to when IV will spike up. Placing bets to benefit from this event is a futile search. Most trades done in anticipation of IV spiking end up in failure. No doubt, once every 2-4 years after IV spikes you will find success story on internet of someone whose VIX call option shot up 100 times. Do, however, note each time it is a different person. For that matter consider that there is always someone winning a lottery too every day somewhere in the world. This approach of paying 2%-4% of your portfolio value to consistently losing strategies cannot be called portfolio insurance. It is actually a tax on the portfolio.

Positioning for the event if IV will spikes requires the patience of a praying mantis. It keeps you on the right side of your investment path. Most MoneyWiseSmart strategies are aligned to this long term philosophy. IV spikes provides the best opportunities to position yourself into businesses you were looking to acquire in long term. We teach these in our Option Series course and also discuss it in our regular tutorials. The higher IV also increases the XIRR on the cash flow generated from our option strategies. This allows you to take a longer term position at a very juicy returns.

 So what about Long VIX?

This is a very good question but please get yourself familiarised with what is VIX. This is a topic we will cover in our Option Series course module later. For now understand these limitations clearly:

1. VIX is not an asset you can own. It is an index and VIX options and future contracts settle on the index value on the expiry date.

1. VIX is almost always in Contango (there have been only four instances of VIX in Backwardation since 2005).  It implies that long VIX positions (futures or synthetically created via options) pay a cost of carry, or lose money daily (ceteris paribus)

Contango is a situation where the futures price (or forward price) of an asset is higher than the expected spot price of the asset at maturity. Backwardation is the opposite where the future price (or forward price) of an asset is lower than the expected spot price of the asset at maturity.

Steep contango in VIX makes the long positions expensive to carry. Unless there is a sudden spike (which VIX is known for), most times these cost of carrying long vix positions comes out of your portfolio. At the same time the short VIX strategy also carries its risk, because spikes in VIX can be of unlimited magnitude and therefore can cause tremendous damage to portfolio if caught on the wrong side.

 How about long dated VIX calls or buying VIX at 20?

Due to VIX term structure, one cannot buy furthest available VIX contract and hope for the spike to translate into windfall profit. You might get spike in March but your August contract would barely budge. It is also a myth that VIX at 20 is some kind of floor. There is no magical bounce from VIX at 20. Over the 29 year since 1991, VIX has spent 64% of time below 20 (based on a crude and quick analysis of VIX monthly chart shown here). VIX at 20 can easily end up at VIX at 15.

I used to joke in my trading circle. Short VIX kills your swiftly, after playing around with you like a black widow spider, while the long VIX bleeds you to death. I would generally advice to observe VIX as an indicator. Please try not to bet on its direction and instead try to harness opportunity elevated IV provides. Position yourself for the event “if” volatility rises instead of trying to predict “when”. For that you must be patient, and have your resources rightly aligned.

Join us in our community to discuss this and other subjects or leave a comment.

Vaibhav Shukla January 2021