The prospect of sharp losses when a crisis hits is one of the biggest fears amongst investors. Unfortunately, everyone who invests for the long haul will run into such episodes sooner or later, and the impact can sometimes be financially and psychologically devastating. This year's early August selloff and sudden surge in volatility is one recent example. Although the recovery came swiftly, it offered a glimpse of what could happen in a more extended downturn.
Using the Long Volatility Trade As a Tactical Hedge
But we are not defenseless. There are ways to mitigate the impact when heavy selling or a black swan hits. You can fight a swan with a swan. One that can give you a payoff high enough to offset losses coming from other positions in your portfolio.
One such approach is to deploy a long volatility position as a hedge. However, maintaining such a hedge all the time can be prohibitively expensive, dragging down your portfolio performance during calm periods. So a more viable method is to use it tactically only when the conditions are right such as when the market is showing signs of complacency and underpricing risk. The drawback is that the hedge will not always be there for every market correction. But as long as it has a good chance of activating during major crises, it can still provide much-needed protection.
Long Volatility Trade in Action: August 2024 Case Study
Let’s take a look at how this strategy played out in a $50,000 portfolio we set up at the start of August 2024.
1 Aug: Setting Up the Volatility Hedge
The portfolio leans heavier on equities accounting for 64% of the total allocation. These were distributed across broad market ETFs representing the S&P 500 (Ticker: SPY), Nasdaq 100 (Ticker: QQQ), as well as energy (Ticker: XLE), healthcare (Ticker: XLV), and utilities (Ticker: XLU) sectors. Another 24% of the capital was used to buy into commodities ETF that invest in diversified agriculture (Ticker: DBA) and Gold (Ticker: GLD). Finally, about 8% of the capital was used to set up a long volatility hedge (Ticker: VIXY) because the signals indicate that the market is underpricing risk.
1 Aug - 6 Aug: Volatility Surges Amid a Market Selloff
The first week of August was plagued by a sharp selloff across risky assets, particularly in technology stocks, and a spike in volatility amid recession concerns. This was further aggravated by an aggressive unwind in the USDJPY carry trade as BOJ looks set to raise rates while the US Federal Reserve is geared to do the opposite. At the worst point, technology stocks as a sector were down as much as 10%.
Despite being more defensively positioned than the broad markets, our long equity positions still came under pressure from the heavy selling. The losses were however more than compensated by our long volatility hedge. Between 1 Aug to 6 Aug, our long volatility position made an exceptional profit of $2,430 due to the surge in volatility while the losses from our other positions were only $1,284.
You can see how much profits the hedge made against other positions and how our portfolio compares with a similar $50,000 in the S&P 500 in the chart below.
For the first 3 trading days of the month, you can see good profits from the hedge while the rest of the positions are taking in losses. Then on 6 June when the market opened, we closed out half our volatility hedge. This partial exit allowed us to secure profits while still retaining exposure in case of further volatility spikes.
On the same day, volatility subsided rapidly, and the hedge gave back part of the profits resulting in a net loss. That is the nature of trading volatility, a fast-moving asset.
7 Aug - 14 Aug: Market Rebounds, Hedge Loses Value
From 7 August to 14 August, the market continued to rebound bolstered by encouraging numbers in inflation and consumer spending. In the meantime, volatility retreated. And even though our long volatility was halved, it still presents a significant drag to the portfolio. But the losses from the hedge were mostly offset by gains from our other positions which were benefitting from the market recovery. That helped to keep the portfolio flat.
The S&P 500, on the other hand, is coming back from its lows and making its way toward breaking even. While our portfolio is lagging, we still outperformed the S&P 500 for the month with a comfortable buffer. Finally, on 14 August, we exited the volatility position totally as the market conditions no longer justified holding it.
14 Aug - 31 Aug: Recovery Continues, Portfolio Rises Unhindered
With the volatility hedge removed, our equity and commodity positions were free to participate fully in the market recovery. For the rest of August, the portfolio moved up with the broader market. finishing with a total profit of $2,600 or +5.2% on the $50,000 we started with. In comparison, an equivalent investment in the S&P 500 returned just +2.0%.
Conclusion
The August 2024 experience demonstrates the power of a tactically deployed long volatility hedge. By using this strategy selectively it’s possible to capture significant gains during turbulent periods. The hedge not only allowed the portfolio to avoid substantial losses but also outperformed the market by the end of the month.
While a long volatility hedge won’t always be present for every market correction, it’s a highly effective tool for managing risk during major crises. By pairing it with a diversified portfolio, investors can navigate periods of extreme volatility while still benefiting from market recoveries, ultimately leading to more robust long-term returns.
Disclaimer:
The information provided in this blog post is for educational and informational purposes only and should not be construed as financial or investment advice. The strategies and examples discussed are based on past market conditions and may not be suitable for all investors. Investing involves risks, including the potential loss of principal. The performance of any investment strategy is not guaranteed, and past performance is not indicative of future results. Always consult with a qualified financial advisor or professional before making any investment decisions. AllQuant is not responsible for any financial losses that may arise from the implementation of strategies or ideas discussed in this post.
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