Description

Are you prepared to shield your investments from the next market downturn? In this episode of Papers With Backtest: An Algorithmic Trading Journey, we dive deep into the intricacies of portfolio protection through the lens of the groundbreaking research paper titled "A Study in Portfolio Diversification Using VIX Options" by Dominic Pololoni. The hosts tackle a pressing dilemma that investors face: how to safeguard their portfolios from significant market drops without incurring excessive costs. This episode is a must-listen for anyone serious about enhancing their investment strategies.

The conversation revolves around the innovative VIX call ladder strategy, which involves purchasing VIX call options with staggered expiration dates to effectively hedge against volatility. Our hosts meticulously dissect how this strategy performed during the tumultuous 2008 financial crisis, revealing its remarkable ability to significantly reduce losses while providing better risk-adjusted returns compared to the conventional 60-40 portfolio model. This analysis not only highlights the effectiveness of the VIX options strategy but also underscores the critical importance of risk management in today’s unpredictable market landscape.

However, as with any investment strategy, there are potential downsides to consider. The hosts candidly discuss the underperformance of the VIX call ladder during low volatility periods and the inherent risks associated with options expiring worthless. This nuanced discussion encourages listeners to weigh the pros and cons, fostering a more sophisticated understanding of how to navigate the complexities of portfolio diversification.

By the end of the episode, you’ll gain valuable insights into why integrating VIX options into your investment strategy could be a game-changer for portfolio protection. The implications of this research extend beyond VIX options, suggesting that the laddered approach could be adapted to other asset classes, enriching your overall risk management framework. Join us as we explore the depths of algorithmic trading and equip yourself with the knowledge to make informed decisions in your investment journey.

Don’t miss out on this enlightening discussion that not only addresses the challenges of portfolio diversification but also offers actionable strategies to enhance your investment resilience. Tune in to Papers With Backtest: An Algorithmic Trading Journey and discover how you can take control of your financial future!

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Transcription

• Speaker #0

  Hello, welcome back to Papers with a Backtest podcast. Today, we dive into another ALGO trading research paper. It's titled, A Study in Portfolio Diversification Using VIX Options by Dominic Pololoni, CBI. And this one tackles a problem I think every investor faces. How do you protect your portfolio from big market drops without constantly paying for protection you might not need? That's like, you know, buying an expensive insurance policy you hope you'll never use.

• Speaker #1

  Yeah, that's exactly the challenge this paper is addressing. And it explores a really interesting tool, VIX call options. So these options have the potential to actually make you money when the market gets volatile. And the paper proposes a specific way to use them for portfolio hedging. They call it a VIX call ladder.

• Speaker #0

  Okay, a ladder. I'm picturing, you know, investors climbing to safety as the market crumbles around them.

• Speaker #1

  Well, not quite. The ladder refers to the way you buy these VIX call options with different expiration dates. So instead of putting all your eggs in one basket, so to speak, you spread your bets across different time frames, maybe. one month two months three months and four months out so it's like having multiple layers of protection in case volatility spikes unexpectedly but isn't that going to get expensive buying all those options that's where the real cleverness of this strategy comes in the paper emphasizes that you only buy these vix call options when the vix index itself is within a specific range between 15 and 50 percent and this is key because it helps you avoid buying options When volatility is already sky high, which is when they'd be the most expensive, it's like, you know, buying that raincoat before the storm hits, not in the middle of a downpour.

• Speaker #0

  That makes a lot of sense. So you're strategically timing your purchases to potentially get the best price for those options. But the real question is, does this actually work? Did this VIX call ladder strategy actually protect portfolios in the real world or at least in backtests?

• Speaker #1

  To test the strategy, the author looked at a pretty standard portfolio, 60 percent stocks and 40 percent bonds. and back tested it from 2008 to 2013. That period, of course, includes the 2008 financial crisis, which is a pretty brutal test for any hedging strategy.

• Speaker #0

  Talk about trial by fire. All right. Give us the results. Did this ladder hold up?

• Speaker #1

  It actually performed quite well. During the 2008 crisis, the strategy significantly reduced losses and smoothed out those wild swings we saw in the market. The paper even compared the VIX call ladder portfolio to a plain 60-40 portfolio without the hedge. and found that the latter achieved almost double the risk adjusted return during those turbulent times. Double.

• Speaker #0

  That's impressive. But there's always a tradeoff, right? Were there any downsides to using this strategy?

• Speaker #1

  You're right. No strategy is perfect. The paper acknowledges that there were times when the VIX call ladder strategy slightly underperformed compared to just holding stocks and bonds. And this usually happened when market volatility was low. And those VIX call options simply expired worthless. It's like paying for insurance but never having to file a claim.

• Speaker #0

  That's the classic cost of peace of mind. But if the gains during those major downturns outweigh the costs during the calmer periods, it could still be a worthwhile tradeoff,

• Speaker #1

  right? That's precisely the argument the paper makes. The author contends that the cost of underperformance during calm times is relatively small compared to the potential benefits during market downturns, especially when you consider the peace of mind it can offer investors. You know, that feeling of knowing you have a safety net, even if you never have to use it.

• Speaker #0

  It's like that old saying, better safe than sorry, especially when you're talking about something as important as your investments. Yeah. Now, the payor also did something really interesting here. They took this VIX call ladder strategy and applied it to historical data, specifically the 1987 stock market crash, Black Monday. Talk about a. blast from the past.

• Speaker #1

  It is fascinating. Of course, we have to keep in mind that this is based on assumptions and limited data since VIX options didn't exist back then. But the results suggest that even during a historic crash like Black Monday, this strategy could have significantly reduced losses in some scenarios. The portfolio even ended up positive despite the market meltdown. Well,

• Speaker #0

  positive returns during Black Monday. Now that's intriguing. But even if it worked in the past. How relevant is this VIX call adder strategy for today's investors?

• Speaker #1

  That's the million dollar question. And while the market is constantly evolving, the principles of risk management and the desire to protect your portfolio remain the same. This paper provides a solid framework for understanding how VIX call options can be used for hedging. And it's definitely something to consider if you're looking for ways to fortify your portfolio in uncertain times. It's definitely food for thought, especially since market drops, even big ones, are inevitable. Now, getting into the specifics of this Bix call ladder, one thing the paper explores is the moneyness of the call options used.

• Speaker #0

  OK, back up for a second. Remind me what moneyness means in the world of options. Sounds like we're talking about how much money you can make, but I know it's more complicated than that.

• Speaker #1

  Right. Moneyness isn't about profit directly. It describes the relationship between the strike price of an option and the current price of whatever that option is based on. In this case, VIX futures contracts. So a VIX call option is in the money if its strike price is lower than the current VIX futures price.

• Speaker #0

  Got it. So what's the paper's take on picking the right moneyness for these VIX call options? Do they recommend going for options that are already in the money?

• Speaker #1

  Actually, they tested several different moneyness levels. And the sweet spot for this strategy seems to be buying VIX calls that are slightly out of the money. Specifically. They recommend options with a strike price that's 135% of the VIX futures price.

• Speaker #0

  Interesting. So there's a balance to strike here. Why not just go for the cheapest options, the ones that are furthest out of the money?

• Speaker #1

  Well, remember, those cheaper options are also less likely to become profitable. If volatility doesn't rise enough, those options could expire worthless and you've lost your premium. Buying slightly out of the money options gives you more leverage, meaning you could capture bigger profits if volatility does spike. But it's riskier.

• Speaker #0

  So it's that classic risk-reward trade-off. The 135% moneyness seems to be the point where those two factors balance out best for this particular strategy. But what about the length of the ladder itself? How far out should those expiration dates be staggered?

• Speaker #1

  That's another key parameter the paper looked at. And they found that using a four-month ladder consistently provided the most effective protection. This means you're always holding four VIX call options, each with a different expiration date. One month.

• Speaker #0

  Two months.

• Speaker #1

  Three months.

• Speaker #0

  And four months out.

• Speaker #1

  So a longer ladder is better in this case. It makes sense intuitively. You have more time for the market to move in a way that benefits your strategy. It's like having a longer safety net to catch you if things go wrong. Exactly. And remember, one of the main benefits of this strategy is that it attempts to reduce those nasty drawdowns, those peak to trough declines that can really hurt your portfolio's value. To see how well it did, the paper compared the VIX call ladder to a few different benchmarks, including a simple 60-40 portfolio of stocks and bonds. a 100% stock portfolio, and even the CBOE VIX tail hedge index, which uses a quantitative trigger to allocate to VIX call options.

• Speaker #0

  Okay, so we've got a good mix of comparisons here. Give us the highlights. How did the ladder stack up?

• Speaker #1

  Across the board, the VIX call ladder strategy outperformed that basic 60-40 portfolio, especially during times of market stress. It significantly reduced the maximum drawdown and boosted the Certino ratio, which is a measure of risk-adjusted returns. This means it offered better protection without sacrificing too much potential for gain.

• Speaker #0

  So it's not just about playing defense. It's about trying to win the game while minimizing the risk of getting knocked out. What about those other benchmarks, the all stock portfolio and that CBOE index?

• Speaker #1

  Against the 100 percent stock portfolio, the results were even more pronounced. The latter helps smooth out the volatility inherent in an all stock portfolio without significantly impacting the overall return. It's like adding shock absorbers to a race car. You can push the limits further without getting thrown off course.

• Speaker #0

  Love that analogy. It really paints a picture of how this strategy might work for more aggressive investors. But what about that CBOE index, which is specifically designed for tail hedging? How did the latter compare to that?

• Speaker #1

  Well, it outperformed the CBOE index in terms of overall risk-adjusted returns, but the CBOE index did slightly better during very specific periods of extreme stress, like the flash crash in 2010. This might be because the CBOE index uses a quantitative trigger. to rapidly increase its allocation to VIX call options. When volatility explodes, it's like having an emergency break that kicks in automatically when things get really hairy.

• Speaker #0

  So each strategy has its strengths and weaknesses, depending on the specific market conditions you're looking at. But let's get back to that historical backtest Black Monday. I'm still fascinated by those results. To me, that's one of the most intriguing parts of this paper.

• Speaker #1

  It really is a thought experiment, but a valuable one, remember. They had to use the VXO index. Which was the precursor to the VIX as a proxy since VIX options didn't exist back then. But even with those limitations, the results suggest that this strategy could have significantly softened the blow of that historic crash. Yeah,

• Speaker #0

  in some cases. Yeah. The portfolio even stayed in positive territory despite that massive market meltdown. That's pretty powerful, even if it's hypothetical. Okay. But let's bring this back to the real world. What are the practical implications of this research for investors who are listening right now?

• Speaker #1

  Well, for one, It highlights the potential of VIX call options as a hedging tool, especially during those market downturns that everyone worries about. The laddered approach, with its staggered expiration dates, helps to smooth out costs and provides a more consistent level of protection over time.

• Speaker #0

  So it's not about trying to perfectly time the market or predict exactly when things are going to go haywire. It's about having a system in place to manage the risk, no matter what happens.

• Speaker #1

  Exactly. And the paper also gives us specific guidelines to work with. Buying slightly out of the money options with that 135% moneyness and using a four month ladder. These are just starting points. You always have to adjust any strategy. Based on your own risk tolerance, your investment goals, and the current market conditions.

• Speaker #0

  It's not a one-size-fits-all approach. But this research gives us a framework to think about how VIX call options might fit into a broader portfolio strategy. But we've talked a lot about the potential benefits here. What about the potential downsides? What should investors be wary of with this VIX call ladder?

• Speaker #1

  The main drawback, as we mentioned earlier, is the cost of underperformance during those calm market periods. When volatility is low, those VIX call options might just expire worthless, and you've lost the premium you paid for them.

• Speaker #0

  It's that classic insurance dilemma. You're paying for protection you hope you'll never need. And if you never need it, you might feel like you've wasted money. Uh-huh. But on the flip side, if the market does crash and you don't have that protection, you might regret not having it even more.

• Speaker #1

  It's a tough balance to strike. And of course, Okay. no hedging strategy is completely foolproof. Even if you have a VIX call ladder in place, there's no guarantee you'll be fully protected from every possible market scenario. Right.

• Speaker #0

  The market can always surprise us. We've seen that time and time again throughout history. But that being said, this VIX call ladder strategy, with its built-in rules and parameters, offers a potentially valuable approach to managing risk, especially for investors who are looking for ways to navigate those periods of heightened market uncertainty.

• Speaker #1

  It's definitely something to consider. Especially if you're the type of investor who values peace of mind, knowing that you have a plan in place to mitigate potential losses, even if it comes at a small cost or in calm times, can really help you stay focused on your long-term investment goals.

• Speaker #0

  Absolutely. And that long-term perspective is what's key. It's easy to get caught up in the day-to-day noise of the market. But at the end of the day, investing is about achieving your financial goals, whether that's retiring comfortably, buying a home, or leaving a legacy for your loved ones.

• Speaker #1

  It's about using your resources wisely and making sure your money is working for you, even during those inevitable periods of market turbulence. OK,

• Speaker #0

  so we've covered a lot of ground today. But before we wrap up, I'd love to get your thoughts on one more thing. The paper focuses specifically on VIX call options. But could this laddered approach, this idea of staggering expiration dates to smooth out costs and provide more consistent protection, be applied to other types of assets as well?

• Speaker #1

  That's a great question, and I think it's an area that's ripe for further exploration. In theory, this framework could be adapted to options on other assets like stocks, dot bonds or even commodities. It could be a way to hedge against risks that are specific to certain investments in your portfolio rather than just hedging against broad market volatility.

• Speaker #0

  So instead of just having a general safety net, you could have targeted protection for specific parts of your portfolio. But I imagine there are some challenges to consider here.

• Speaker #1

  Of course. The liquidity and pricing dynamics of options on individual stocks or commodities might be very different from VIX options. And the optimal parameters for the latter, the moneyness, the expiration dates, the allocation, would likely need to be adjusted based on the characteristics of the underlying asset.

• Speaker #0

  It's definitely not a simple copy and paste operation. But the underlying principle, the idea of using this laddered structure, is still incredibly valuable. This paper really opens up a whole new way of thinking about how to use options in a more strategic way to manage risk. It's not just about buying puts to protect your downside. It's about thinking more creatively and finding ways to customize your approach based on your own specific needs and goals.

• Speaker #1

  I couldn't agree more. And I think that's one of the most important takeaways from this research. It's about encouraging investors to think beyond the traditional approaches to risk management and to really explore the possibilities of using options. In a more nuanced and tailored way.

• Speaker #0

  So it's not just about following a set of rules blindly. It's about understanding the principles behind those rules. Yeah. And then using that knowledge to build a strategy that truly reflects your own unique circumstances and objectives.

• Speaker #1

  Absolutely. And I think that's what makes this research so valuable. It's not just giving us a specific strategy to follow. It's giving us a framework for thinking about risk management in a more holistic and personalized way.

• Speaker #0

  Well, on that note of personalized risk management, not this time for us to wrap up this episode, but before we do, I just want to say a huge thank you to you for sharing your expertise and insights with our listeners today. It's been a truly fascinating discussion.

• Speaker #1

  It's been my pleasure. I always enjoy the opportunity to talk about this kind of research.

• Speaker #0

  Well, we certainly appreciate it. And to all of our listeners out there, we hope this deep dive has given you some valuable food for thought. Remember, the world of investing is constantly evolving, so it's essential to stay curious, stay informed. And never stop learning.

• Speaker #1

  And don't be afraid to challenge the conventional wisdom and explore new ideas and approaches, after all. That's how progress happens.

• Speaker #0

  Absolutely. So with that in mind, we will sign off for today. But be sure to join us next time as we continue our mission of unpacking the latest and greatest research. in the world of algo trading. And for more papers, backtests, and insightful discussions, be sure to visit us at https.paperswithbacktests.com. Until then, happy trading.

• Speaker #1

  And happy investing.

• Speaker #0

  Thank you for tuning in to Papers with Backtests podcast. We hope today's episode gave you useful insights. Join us next time as we break down more research. And for more papers and backtests, find us at https.paperswithbacktests.com. Happy trading.