Capturing the Volatility Risk Premium

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FiveFactor
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Capturing the Volatility Risk Premium

Post by FiveFactor »

Primer: https://images.aqr.com/-/media/AQR/Docu ... remium.pdf

My assumption is that as the value / growth spread narrows I’ll be reducing value/profitability exposure, and adding diversified sources of risk. 1) term, 2) volatility. For volatility risk premium, I like ARQs implementation, but I can’t get to the $5m Min for this slice of my portfolio. That said I do like selling insurance in the market, and it makes sense that implied volatility tends to be higher than realized volatility - so there is a premium there to be had (story + data). I keep gravitating to PUTW as the tool for this.

Thoughts? How do you target the VRP?
Small/Value/Profitability: | 30% AVUV | 30% AVDV | 30% AVES | Momentum: | 5% QMOM | 5% IMOM | Volatility: | 0.1% PUTW | Term: | 0.1% BND
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Re: Capturing the Volatility Risk Premium

Post by nedsaid »

Stone Ridge had a fund based upon the Variance Risk Premium and evidently it was taken to the vet and put out of its misery. Great concept but somehow didn't work in practice. I started a thread on this fund.

viewtopic.php?f=10&t=345116
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FiveFactor
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Re: Capturing the Volatility Risk Premium

Post by FiveFactor »

Thanks. Looks like the fund is defunct. Do you know if they were following a put write strategy on productive assets?
Small/Value/Profitability: | 30% AVUV | 30% AVDV | 30% AVES | Momentum: | 5% QMOM | 5% IMOM | Volatility: | 0.1% PUTW | Term: | 0.1% BND
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Re: Capturing the Volatility Risk Premium

Post by nedsaid »

FiveFactor wrote: Sat Oct 16, 2021 4:29 am Thanks. Looks like the fund is defunct. Do you know if they were following a put write strategy on productive assets?
Lots of threads regarding the Stone Ridge fund, I think this was pretty thoroughly discussed. I had to go back to old posts to refresh my memory. In effect, what you said seems right, they executed this strategy across multiple asset classes and reaching back to very foggy memory banks seem to remember that they employed leverage as well.
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Re: Capturing the Volatility Risk Premium

Post by FiveFactor »

Leverage would blow things up. I think one poor implementation of a risk factor should not discredit the existence. PUTW looks to avoid the liquidity and leverage traps of stone ridge.
Small/Value/Profitability: | 30% AVUV | 30% AVDV | 30% AVES | Momentum: | 5% QMOM | 5% IMOM | Volatility: | 0.1% PUTW | Term: | 0.1% BND
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Re: Capturing the Volatility Risk Premium

Post by Forester »

So we have one camp touting the Volatility Risk Premium, scalping pennies from left tail insurers, then another camp (Spitznagel etc) who claim/are able to provide deep crash protection with minimal bleed.

I don't see how both approaches can profit consistently and at scale but that's my uneducated gut feel take.
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Re: Capturing the Volatility Risk Premium

Post by FiveFactor »

Forester wrote: Sat Oct 16, 2021 7:03 am So we have one camp touting the Volatility Risk Premium, scalping pennies from left tail insurers, then another camp (Spitznagel etc) who claim/are able to provide deep crash protection with minimal bleed.

I don't see how both approaches can profit consistently and at scale but that's my uneducated gut feel take.
Doesn’t sound to me like Spitzagel is claiming to consistently profit. More like minimize the cost of insurance for left tail…. Unless there is a paper?

Edit: and in this case both strategies are viable depending on individual portfolio needs
Small/Value/Profitability: | 30% AVUV | 30% AVDV | 30% AVES | Momentum: | 5% QMOM | 5% IMOM | Volatility: | 0.1% PUTW | Term: | 0.1% BND
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Re: Capturing the Volatility Risk Premium

Post by JoMoney »

FiveFactor wrote: Sat Oct 16, 2021 4:12 am...
Thoughts? How do you target the VRP?
I don't, and I find the "Risk Premium" models for investing largely without merit. ...some exceptions for being a good story to sell people that have given up on skilled management on active mutual funds, and a way to give quants numbers to play with despite it having poor predictive value.
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Re: Capturing the Volatility Risk Premium

Post by Shallowpockets »

I read through that article. Sounds like a pitch. OP. How about giving us some numbers. Your personal numbers. Have you made money? How much, on what? Or is it just scraping pennies.
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Re: Capturing the Volatility Risk Premium

Post by FiveFactor »

Shallowpockets wrote: Sat Oct 16, 2021 7:44 am I read through that article. Sounds like a pitch. OP. How about giving us some numbers. Your personal numbers. Have you made money? How much, on what? Or is it just scraping pennies.
I’m not trying to educate. I am am asking implementation experience from others who have gone down the VRP road. If you are interested in educating yourself then Google “volatility risk premium” and “put write strategies”
Small/Value/Profitability: | 30% AVUV | 30% AVDV | 30% AVES | Momentum: | 5% QMOM | 5% IMOM | Volatility: | 0.1% PUTW | Term: | 0.1% BND
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Re: Capturing the Volatility Risk Premium

Post by zkn »

Forester wrote: Sat Oct 16, 2021 7:03 am So we have one camp touting the Volatility Risk Premium, scalping pennies from left tail insurers, then another camp (Spitznagel etc) who claim/are able to provide deep crash protection with minimal bleed.

I don't see how both approaches can profit consistently and at scale but that's my uneducated gut feel take.
Maybe both cannot profit consistently, but both can win.

When the trade is seen in isolation, the short volatility investor (i.e., the seller of insurance) should profit on average over a long period of time, and the long volatility investor (i.e., the buyer of insurance) should lose. However, the long volatility investor has the potential for large injections of capital during sharp market crashes, providing an opportunity to buy at cheap valuations, and then profiting from a potential rebound. So potentially both sides can profit when you consider not only the volatility trade but the whole portfolio of both sides.
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Re: Capturing the Volatility Risk Premium

Post by FiveFactor »

zkn wrote: Sat Oct 16, 2021 7:54 am
Forester wrote: Sat Oct 16, 2021 7:03 am So we have one camp touting the Volatility Risk Premium, scalping pennies from left tail insurers, then another camp (Spitznagel etc) who claim/are able to provide deep crash protection with minimal bleed.

I don't see how both approaches can profit consistently and at scale but that's my uneducated gut feel take.
Maybe both cannot profit consistently, but both can win.

When the trade is seen in isolation, the short volatility investor (i.e., the seller of insurance) should profit on average over a long period of time, and the long volatility investor (i.e., the buyer of insurance) should lose. However, the long volatility investor has the potential for large injections of capital during sharp market crashes, providing an opportunity to buy at cheap valuations, and then profiting from a potential rebound. So potentially both sides can profit when you consider not only the volatility trade but the whole portfolio of both sides.
It’s almost like they are mathematically designed insura ce products for that purpose?
Small/Value/Profitability: | 30% AVUV | 30% AVDV | 30% AVES | Momentum: | 5% QMOM | 5% IMOM | Volatility: | 0.1% PUTW | Term: | 0.1% BND
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Re: Capturing the Volatility Risk Premium

Post by JoMoney »

zkn wrote: Sat Oct 16, 2021 7:54 am
Forester wrote: Sat Oct 16, 2021 7:03 am So we have one camp touting the Volatility Risk Premium, scalping pennies from left tail insurers, then another camp (Spitznagel etc) who claim/are able to provide deep crash protection with minimal bleed.

I don't see how both approaches can profit consistently and at scale but that's my uneducated gut feel take.
Maybe both cannot profit consistently, but both can win.

When the trade is seen in isolation, the short volatility investor (i.e., the seller of insurance) should profit on average over a long period of time, and the long volatility investor (i.e., the buyer of insurance) should lose. However, the long volatility investor has the potential for large injections of capital during sharp market crashes, providing an opportunity to buy at cheap valuations, and then profiting from a potential rebound. So potentially both sides can profit when you consider not only the volatility trade but the whole portfolio of both sides.
They can only both "win" if they define "winning" differently, i.e. using different objectives as the measure, or trying to compare different time periods... Using the same measure over the same time period, options are a zero sum game, by any amount one side "wins" the other side loses... (less all the fees going to brokers, market makers, and middle-men)
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham
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Re: Capturing the Volatility Risk Premium

Post by FiveFactor »

JoMoney wrote: Sat Oct 16, 2021 8:06 am
zkn wrote: Sat Oct 16, 2021 7:54 am
Forester wrote: Sat Oct 16, 2021 7:03 am So we have one camp touting the Volatility Risk Premium, scalping pennies from left tail insurers, then another camp (Spitznagel etc) who claim/are able to provide deep crash protection with minimal bleed.

I don't see how both approaches can profit consistently and at scale but that's my uneducated gut feel take.
Maybe both cannot profit consistently, but both can win.

When the trade is seen in isolation, the short volatility investor (i.e., the seller of insurance) should profit on average over a long period of time, and the long volatility investor (i.e., the buyer of insurance) should lose. However, the long volatility investor has the potential for large injections of capital during sharp market crashes, providing an opportunity to buy at cheap valuations, and then profiting from a potential rebound. So potentially both sides can profit when you consider not only the volatility trade but the whole portfolio of both sides.
They can only both "win" if they define "winning" differently, i.e. using different objectives as the measure, or trying to compare different time periods... Using the same measure over the same time period, options are a zero sum game, by any amount one side "wins" the other side loses... (less all the fees going to brokers, market makers, and middle-men)
Of course the people who sell insurance have different objectives than the people buying insurance. That’s a core truth to the very existence of insurance markets.
Small/Value/Profitability: | 30% AVUV | 30% AVDV | 30% AVES | Momentum: | 5% QMOM | 5% IMOM | Volatility: | 0.1% PUTW | Term: | 0.1% BND
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Re: Capturing the Volatility Risk Premium

Post by zkn »

JoMoney wrote: Sat Oct 16, 2021 8:06 am
zkn wrote: Sat Oct 16, 2021 7:54 am
Forester wrote: Sat Oct 16, 2021 7:03 am So we have one camp touting the Volatility Risk Premium, scalping pennies from left tail insurers, then another camp (Spitznagel etc) who claim/are able to provide deep crash protection with minimal bleed.

I don't see how both approaches can profit consistently and at scale but that's my uneducated gut feel take.
Maybe both cannot profit consistently, but both can win.

When the trade is seen in isolation, the short volatility investor (i.e., the seller of insurance) should profit on average over a long period of time, and the long volatility investor (i.e., the buyer of insurance) should lose. However, the long volatility investor has the potential for large injections of capital during sharp market crashes, providing an opportunity to buy at cheap valuations, and then profiting from a potential rebound. So potentially both sides can profit when you consider not only the volatility trade but the whole portfolio of both sides.
They can only both "win" if they define "winning" differently, i.e. using different objectives as the measure, or trying to compare different time periods... Using the same measure over the same time period, options are a zero sum game, by any amount one side "wins" the other side loses... (less all the fees going to brokers, market makers, and middle-men)
That's the whole point. Investors have different objectives, and considering the short/long volatility options trade in isolation does not provide the whole picture as the rest of the portfolio changes the objectives for the trade. The long volatility investor in particular is most likely trying to optimize their whole portfolio according to some objective by including protection, not profit from the long volatility trade in isolation.
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Re: Capturing the Volatility Risk Premium

Post by FiveFactor »

zkn wrote: Sat Oct 16, 2021 8:18 am
JoMoney wrote: Sat Oct 16, 2021 8:06 am
zkn wrote: Sat Oct 16, 2021 7:54 am
Forester wrote: Sat Oct 16, 2021 7:03 am So we have one camp touting the Volatility Risk Premium, scalping pennies from left tail insurers, then another camp (Spitznagel etc) who claim/are able to provide deep crash protection with minimal bleed.

I don't see how both approaches can profit consistently and at scale but that's my uneducated gut feel take.
Maybe both cannot profit consistently, but both can win.

When the trade is seen in isolation, the short volatility investor (i.e., the seller of insurance) should profit on average over a long period of time, and the long volatility investor (i.e., the buyer of insurance) should lose. However, the long volatility investor has the potential for large injections of capital during sharp market crashes, providing an opportunity to buy at cheap valuations, and then profiting from a potential rebound. So potentially both sides can profit when you consider not only the volatility trade but the whole portfolio of both sides.
They can only both "win" if they define "winning" differently, i.e. using different objectives as the measure, or trying to compare different time periods... Using the same measure over the same time period, options are a zero sum game, by any amount one side "wins" the other side loses... (less all the fees going to brokers, market makers, and middle-men)
That's the whole point. Investors have different objectives, and considering the short/long volatility options trade in isolation does not provide the whole picture as the rest of the portfolio changes the objectives for the trade. The long volatility investor in particular is most likely trying to optimize their whole portfolio according to some objective by including protection, not profit from the long volatility trade in isolation.
This. It’s a way to transfer risk. there is an expected premium to taking that risk. And an expected cost to putting that risk on someone else. Hence VRP.

But we are off topic. I get that a leveraged multi-asset boutique fund with 2% expenses didn’t do well in the worst time for volatility risk. The question is more on the PUTW implementation. Much more straightforward than ARQ or stone. No leverage. Good AUM. Thrived since Covid. Correlation to the rest of my portfolio are very attractive.
Small/Value/Profitability: | 30% AVUV | 30% AVDV | 30% AVES | Momentum: | 5% QMOM | 5% IMOM | Volatility: | 0.1% PUTW | Term: | 0.1% BND
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Re: Capturing the Volatility Risk Premium

Post by nisiprius »

FiveFactor wrote: Sat Oct 16, 2021 5:48 am Leverage would blow things up. I think one poor implementation of a risk factor should not discredit the existence. PUTW looks to avoid the liquidity and leverage traps of stone ridge.
Perhaps, but note that Larry Swedroe repeatedly recommended AVRPX, and said that "my firm, Buckingham Strategic Wealth" recommended it "in constructing client portfolios." He recommended it explicitly by ticker symbol, and over a period of several years, in books, articles, and postings in this forum. So he must have not have spotted the problem in its implementation. For example, in 2018: The Four Horsemen of Your Portfolio
Larry Swedroe wrote:For investors who need more return than safe bonds can provide, there are safer alternatives than either junk bonds or additional equity investment. We recommend allocations to four alternatives, each of which we believe has equitylike returns with much lower volatility.

The four alternatives we use are the AQR Style Premia Alternative Fund (QSPRX) and three funds from Stone Ridge: LENDX, an alternative lending (small business, consumer and student loans) fund; SRRIX, a reinsurance fund; and AVRPX, a fund that sells volatility insurance across stocks, bonds, currencies and commodities.

We believe an equal-weighted portfolio of these four funds has forward-looking return expectations similar to those of a global equity portfolio, but with only about one-quarter of the volatility of equities (5% versus 20%). (In the interest of full disclosure, as noted, my firm, Buckingham Strategic Wealth, recommends AQR and Stone Ridge funds in constructing client portfolios.)
Last edited by nisiprius on Sat Oct 16, 2021 8:51 am, edited 2 times in total.
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Re: Capturing the Volatility Risk Premium

Post by JackoC »

FiveFactor wrote: Sat Oct 16, 2021 7:33 am
Forester wrote: Sat Oct 16, 2021 7:03 am So we have one camp touting the Volatility Risk Premium, scalping pennies from left tail insurers, then another camp (Spitznagel etc) who claim/are able to provide deep crash protection with minimal bleed.

I don't see how both approaches can profit consistently and at scale but that's my uneducated gut feel take.
Doesn’t sound to me like Spitzagel is claiming to consistently profit. More like minimize the cost of insurance for left tail…. Unless there is a paper?

Edit: and in this case both strategies are viable depending on individual portfolio needs
I agree it might seem on the surface that the two ideas are necessarily opposed but are not. Mainly because tail hedging with stock index puts, of which Spitznagel's particular approach* is just one of numerous variations, is not based on supposing a negative volatility risk premium. The simple explanation of how tail hedging can 'win' is if it allows you to maintain a higher allocation to tail hedged equities than you'd be willing to have without tail hedges. Looking for 'profit' in the tail hedges themselves is basically off track. As whenever this comes up I'll repeat, if you're willing to be 100% equities and not willing to leverage, there is no reason to tail hedge. The potential tail hedger is somebody only willing to be, for example, 60/40 without tail hedges, if tail hedging would make them accept, say, 100% equity with tail hedges. And if you look at sales stuff from Universa (Spitznagel's outfit) that's the comparison, which is conceptually the right one.

The classic example of vol risk premium harvesting is Putwrite, easy to look up the results of that strategy per CBOE. It did very well for a long time since the availability of real option data in the early 1990's (various people have synthesized what index option prices *should* have been going back many decades but obviously there's a tradeoff there between bigger sample and certainty the data is worthwhile). Return was higher than the S&P IIRC into the 2010's (it should be lower, because the risk is lower), and Sharpe Ratio might still be higher inception to date. But as they say 'you can't eat Sharpe Ratio', or less flippantly the value of high SR depends on confidence to leverage up something with lower expected return but higher SR. Anyway Putwrite and tail hedging would not be contradictory, but complimentary. If you concluded Putwrite would continue to have superior SR, you might gain the confidence to leverage it up by also having tail hedges. Again just because your tail hedges are SPX puts doesn't mean you believe in a negative VRP.

*at least sketchily outlined in publicly available papers though with the usual caveat 'if you invest with us we'll do propriety versions of this general idea which are better but we won't specify details for free'.
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Re: Capturing the Volatility Risk Premium

Post by nisiprius »

Shallowpockets wrote: Sat Oct 16, 2021 7:44 am I read through that article. Sounds like a pitch.
Since the paper is by AQR and dated 5/11/2018, I think it's likely that it was intended to support the implementation and strategy behind the AQR Volatility Risk Premium Fund, QVPIX/QVPNX/QVPRX, which launched 11/1/2018.

I note that AQR's description says "The Fund’s volatility risk premium strategy will be implemented, in part, by selling (writing) put and call options," so it sounds like a legitimate member of the same family as PUTW.

I wonder how QVPIX has been doing?

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Re: Capturing the Volatility Risk Premium

Post by FiveFactor »

nisiprius wrote: Sat Oct 16, 2021 8:40 am
Shallowpockets wrote: Sat Oct 16, 2021 7:44 am I read through that article. Sounds like a pitch.
Since the paper is by AQR and dated 5/11/2018, I think it's likely that it was intended to support the implementation and strategy behind the AQR Volatility Risk Premium Fund, QVPIX/QVPNX/QVPRX, which launched 11/1/2018.

I note that AQR's description says "The Fund’s volatility risk premium strategy will be implemented, in part, by selling (writing) put and call options," so it sounds like a legitimate member of the same family as PUTW.

I wonder how QVPIX has been doing?

Image

Not well.
If a fund going under is evidence of a defunct risk factor, you best be prepared to sell all your financial assets exposed to the equity risk premium
Small/Value/Profitability: | 30% AVUV | 30% AVDV | 30% AVES | Momentum: | 5% QMOM | 5% IMOM | Volatility: | 0.1% PUTW | Term: | 0.1% BND
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Re: Capturing the Volatility Risk Premium

Post by Valuethinker »

FiveFactor wrote: Sat Oct 16, 2021 9:08 am
nisiprius wrote: Sat Oct 16, 2021 8:40 am
Shallowpockets wrote: Sat Oct 16, 2021 7:44 am I read through that article. Sounds like a pitch.
Since the paper is by AQR and dated 5/11/2018, I think it's likely that it was intended to support the implementation and strategy behind the AQR Volatility Risk Premium Fund, QVPIX/QVPNX/QVPRX, which launched 11/1/2018.

I note that AQR's description says "The Fund’s volatility risk premium strategy will be implemented, in part, by selling (writing) put and call options," so it sounds like a legitimate member of the same family as PUTW.

I wonder how QVPIX has been doing?

Image

Not well.
If a fund going under is evidence of a defunct risk factor, you best be prepared to sell all your financial assets exposed to the equity risk premium
Beware of reasoning by false analogy.
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Re: Capturing the Volatility Risk Premium

Post by FiveFactor »

Valuethinker wrote: Sat Oct 16, 2021 11:05 am
Beware of reasoning by false analogy.
Was there evidence beyond a single fund closing that was presented? Otherwise, it’s a 100% accurate analogy. Remember, insurance markets are older than equity markets.
Small/Value/Profitability: | 30% AVUV | 30% AVDV | 30% AVES | Momentum: | 5% QMOM | 5% IMOM | Volatility: | 0.1% PUTW | Term: | 0.1% BND
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Re: Capturing the Volatility Risk Premium

Post by secondopinion »

Forester wrote: Sat Oct 16, 2021 7:03 am So we have one camp touting the Volatility Risk Premium, scalping pennies from left tail insurers, then another camp (Spitznagel etc) who claim/are able to provide deep crash protection with minimal bleed.

I don't see how both approaches can profit consistently and at scale but that's my uneducated gut feel take.
The insurance writers are more likely to win than the insurance takers by definition. Risk skew 101: those who hope for massive outperformance without taking additional volatility (definition of positive risk skew) will very likely underperform mildly; those who take the unlikely massive underperformance without taking additional volatility will likely outperform mildly. It does not state, however, who will win in the long-run.
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Re: Capturing the Volatility Risk Premium

Post by secondopinion »

JackoC wrote: Sat Oct 16, 2021 8:31 am
FiveFactor wrote: Sat Oct 16, 2021 7:33 am
Forester wrote: Sat Oct 16, 2021 7:03 am So we have one camp touting the Volatility Risk Premium, scalping pennies from left tail insurers, then another camp (Spitznagel etc) who claim/are able to provide deep crash protection with minimal bleed.

I don't see how both approaches can profit consistently and at scale but that's my uneducated gut feel take.
Doesn’t sound to me like Spitzagel is claiming to consistently profit. More like minimize the cost of insurance for left tail…. Unless there is a paper?

Edit: and in this case both strategies are viable depending on individual portfolio needs
I agree it might seem on the surface that the two ideas are necessarily opposed but are not. Mainly because tail hedging with stock index puts, of which Spitznagel's particular approach* is just one of numerous variations, is not based on supposing a negative volatility risk premium. The simple explanation of how tail hedging can 'win' is if it allows you to maintain a higher allocation to tail hedged equities than you'd be willing to have without tail hedges. Looking for 'profit' in the tail hedges themselves is basically off track. As whenever this comes up I'll repeat, if you're willing to be 100% equities and not willing to leverage, there is no reason to tail hedge. The potential tail hedger is somebody only willing to be, for example, 60/40 without tail hedges, if tail hedging would make them accept, say, 100% equity with tail hedges. And if you look at sales stuff from Universa (Spitznagel's outfit) that's the comparison, which is conceptually the right one.

The classic example of vol risk premium harvesting is Putwrite, easy to look up the results of that strategy per CBOE. It did very well for a long time since the availability of real option data in the early 1990's (various people have synthesized what index option prices *should* have been going back many decades but obviously there's a tradeoff there between bigger sample and certainty the data is worthwhile). Return was higher than the S&P IIRC into the 2010's (it should be lower, because the risk is lower), and Sharpe Ratio might still be higher inception to date. But as they say 'you can't eat Sharpe Ratio', or less flippantly the value of high SR depends on confidence to leverage up something with lower expected return but higher SR. Anyway Putwrite and tail hedging would not be contradictory, but complimentary. If you concluded Putwrite would continue to have superior SR, you might gain the confidence to leverage it up by also having tail hedges. Again just because your tail hedges are SPX puts doesn't mean you believe in a negative VRP.

*at least sketchily outlined in publicly available papers though with the usual caveat 'if you invest with us we'll do propriety versions of this general idea which are better but we won't specify details for free'.
That is kind of accurate but misses the reason altogether of the position. If you look at the delta, tail hedges often decrease that delta. You are correct in that delta has been decreased and 100% stocks is like 60/40 with the hedge (given a -40 delta hedge). However, you miss the point of the position; the position is both positively risk skewed with returns and convex.

To illustrate, let us look at the comparison of a -40 delta put option with 100% stocks versus 60/40. Same delta initially. For the hedged equity to outperform 60/40; stocks either have to move up or down a lot quickly. The traditional breaking even point for the put option on the downside is not enough to ensure outperformance; we have to pass it considerably so that the losses on the 60/40 is greater than for the hedged equity. However, the upside of the hedged equity could outperform the 60/40.

Suppose the put was 2.5% and the drop to reach the put was 2%. Maximum loss on the downside is 4.5% for the hedged equity. For 60/40 then to underperform on the down side, we would need to sustain an 7.5% drop or more on the price. On the flip side, the loss on the upside is 2.5% for the hedged equity. For the 60/40 to underperform, the price would need to rise 6.25% or more. It could be 40% chance that the hedged equity would outpeform the 60/40 (with the chance of unlikely major outperformance). However, it is likely that losses of non-trivial amounts will occur.

These are rough numbers, but the point remains that hedged equity does behave differently than a simple 60/40.
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Re: Capturing the Volatility Risk Premium

Post by FiveFactor »

^^^. Correct.

And so to capture the VRP one seems to have to be on the side of selling insurance. We can do that with cash backed puts. We can do that with covered calls. Straightforward two sided coin. The reason I like the puts it tax control.
Small/Value/Profitability: | 30% AVUV | 30% AVDV | 30% AVES | Momentum: | 5% QMOM | 5% IMOM | Volatility: | 0.1% PUTW | Term: | 0.1% BND
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Re: Capturing the Volatility Risk Premium

Post by nisiprius »

FiveFactor wrote: Sat Oct 16, 2021 11:07 amWas there evidence beyond a single fund closing that was presented? Otherwise, it’s a 100% accurate analogy. Remember, insurance markets are older than equity markets.
I wasn't presenting evidence of anything in particular. I was poking around.

I had no idea the AQR fund had closed. The AQR piece sounded like promotion for an upcoming fund, so I searched for "aqr volatility risk premium fund" and it popped up. I was curious as to why FiveFactor hadn't considered it first since you'd expect it to be the most faithful example of the strategy presented in the paper--and an interesting comparison with PUTW. I was getting ready to compare them. And I couldn't find it.

I don't have an exhaustive list, but we have had:

†AVRPX, the Stone Ridge All Asset Variance Fund, 2014-2020
†AQR Volatility Risk Premium Fund 2018-2020
PUTW, the Wisdomtree PutWrite Strategy Fund, Mar 2016-present
NUPAX, the Neuberger Berman U.S. Equity Index PutWrite Strategy Fund, Oct 2016-present

Any more?

PUTW and NUPAX are about the same age. Over that short period of time NUPAX has done a bit better.

Image

PIMCO has an article on The Volatility Risk Premium but I can't find any PIMCO fund that targets it.
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nedsaid
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Re: Capturing the Volatility Risk Premium

Post by nedsaid »

nisiprius wrote: Sat Oct 16, 2021 1:55 pm
I don't have an exhaustive list, but we have had:

†AVRPX, the Stone Ridge All Asset Variance Fund, 2014-2020
†AQR Volatility Risk Premium Fund 2018-2020
†Larry Swedroe, Bogleheads, 2007-2020.
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Re: Capturing the Volatility Risk Premium

Post by FiveFactor »

nisiprius wrote: Sat Oct 16, 2021 1:55 pm. I was curious as to why FiveFactor hadn't considered it first since you'd expect it to be the most faithful example of the strategy presented in the paper--and an interesting comparison with PUTW. I was getting ready to compare them. And I couldn't find it.
I don’t like the ARQ or stone ridge implementations. I do think Cliff does great research. My issues with the implementation, 1) covers non productive assets, 2) expenses…. Very high expenses.

PUTW addresses both of those well.

The PIMCO paper supports my research. Good read.
Small/Value/Profitability: | 30% AVUV | 30% AVDV | 30% AVES | Momentum: | 5% QMOM | 5% IMOM | Volatility: | 0.1% PUTW | Term: | 0.1% BND
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Re: Capturing the Volatility Risk Premium

Post by secondopinion »

FiveFactor wrote: Sat Oct 16, 2021 1:43 pm ^^^. Correct.

And so to capture the VRP one seems to have to be on the side of selling insurance. We can do that with cash backed puts. We can do that with covered calls. Straightforward two sided coin. The reason I like the puts it tax control.
This assumes that selling the puts is profitable. Although I think it is profitable usually, remember that the case where implied volatility goes up is usually when stock prices go down. Therefore, assuming fairness implies that a negative risk skew beyond the normal amount exists (higher likelihoods of gains, higher potential losses). But, the question remains if selling -40 delta puts gains you more than what a 40/60 would give you on average. But you are certainly going to obtain more frequent outperformance assuming fairness.
Passive investing: not about making big bucks but making profits. Active investing: not about beating the market but meeting goals. Speculation: not about timing the market but taking profitable risks.
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Re: Capturing the Volatility Risk Premium

Post by FiveFactor »

secondopinion wrote: Sat Oct 16, 2021 2:54 pm
FiveFactor wrote: Sat Oct 16, 2021 1:43 pm ^^^. Correct.

And so to capture the VRP one seems to have to be on the side of selling insurance. We can do that with cash backed puts. We can do that with covered calls. Straightforward two sided coin. The reason I like the puts it tax control.
This assumes that selling the puts is profitable. Although I think it is profitable usually, remember that the case where implied volatility goes up is usually when stock prices go down. Therefore, assuming fairness implies that a negative risk skew beyond the normal amount exists (higher likelihoods of gains, higher potential losses). But, the question remains if selling -40 delta puts gains you more than what a 40/60 would give you on average.
Yup. Shocks are bad for the strategy. Slow steady gains, very good. Over the long run it’s been a profitable strategy with lower than equity volatility . It also runs ~0.6 correlation with everything else in my portfolio.

Will eventually pair with term risk as well.
Small/Value/Profitability: | 30% AVUV | 30% AVDV | 30% AVES | Momentum: | 5% QMOM | 5% IMOM | Volatility: | 0.1% PUTW | Term: | 0.1% BND
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Re: Capturing the Volatility Risk Premium

Post by Northern Flicker »

Volatile assets are risky assets with risk compensated by the market. The best way to capture the volatility/risk premium is to hold the volatile asset.

Maybe you are asking what asset does well when volatility is high and poorly when it is low?
Last edited by Northern Flicker on Sat Oct 16, 2021 3:35 pm, edited 1 time in total.
secondopinion
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Re: Capturing the Volatility Risk Premium

Post by secondopinion »

FiveFactor wrote: Sat Oct 16, 2021 2:58 pm
secondopinion wrote: Sat Oct 16, 2021 2:54 pm
FiveFactor wrote: Sat Oct 16, 2021 1:43 pm ^^^. Correct.

And so to capture the VRP one seems to have to be on the side of selling insurance. We can do that with cash backed puts. We can do that with covered calls. Straightforward two sided coin. The reason I like the puts it tax control.
This assumes that selling the puts is profitable. Although I think it is profitable usually, remember that the case where implied volatility goes up is usually when stock prices go down. Therefore, assuming fairness implies that a negative risk skew beyond the normal amount exists (higher likelihoods of gains, higher potential losses). But, the question remains if selling -40 delta puts gains you more than what a 40/60 would give you on average.
Yup. Shocks are bad for the strategy. Slow steady gains, very good. Over the long run it’s been a profitable strategy with lower than equity valuations. It also runs ~0.6 correlation with everything else in my portfolio.

Will eventually pair with term risk as well.
Furthermore, we need to understand that there are two risks taken by writing puts aside from the delta (market risk): the volatility risk and the gamma risk. Volatility risk is the risk that changes in volatility affect the prices of the option; gamma risk is the risk because favorable movements are not as profitable as unfavorable are unprofitable when prices changes. A volatility risk premium may exist, but that is supposing that volatility is priced too much into options. That might be true; but then again, is volatility risk negatively skewed (usually slightly overpriced, but majorly underpriced in infrequent cases)? Market risk behaves that way (hence why bears are quicker to destroy than bulls are to build). Also, gamma risk I think is already negatively skewed by definition. Then again, are there vomma, gamma of gamma, and other higher degree risk premiums?

Maybe too much to worry about, but it is definitely not the expected returns/volatility analysis that the Sharpe ratio only considers.
Passive investing: not about making big bucks but making profits. Active investing: not about beating the market but meeting goals. Speculation: not about timing the market but taking profitable risks.
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Re: Capturing the Volatility Risk Premium

Post by JackoC »

secondopinion wrote: Sat Oct 16, 2021 12:47 pm
JackoC wrote: Sat Oct 16, 2021 8:31 am
FiveFactor wrote: Sat Oct 16, 2021 7:33 am
Forester wrote: Sat Oct 16, 2021 7:03 am So we have one camp touting the Volatility Risk Premium, scalping pennies from left tail insurers, then another camp (Spitznagel etc) who claim/are able to provide deep crash protection with minimal bleed.

I don't see how both approaches can profit consistently and at scale but that's my uneducated gut feel take.
Doesn’t sound to me like Spitzagel is claiming to consistently profit. More like minimize the cost of insurance for left tail…. Unless there is a paper?

Edit: and in this case both strategies are viable depending on individual portfolio needs
I agree it might seem on the surface that the two ideas are necessarily opposed but are not. Mainly because tail hedging with stock index puts, of which Spitznagel's particular approach* is just one of numerous variations, is not based on supposing a negative volatility risk premium. The simple explanation of how tail hedging can 'win' is if it allows you to maintain a higher allocation to tail hedged equities than you'd be willing to have without tail hedges. Looking for 'profit' in the tail hedges themselves is basically off track. As whenever this comes up I'll repeat, if you're willing to be 100% equities and not willing to leverage, there is no reason to tail hedge. The potential tail hedger is somebody only willing to be, for example, 60/40 without tail hedges, if tail hedging would make them accept, say, 100% equity with tail hedges. And if you look at sales stuff from Universa (Spitznagel's outfit) that's the comparison, which is conceptually the right one.

The classic example of vol risk premium harvesting is Putwrite, easy to look up the results of that strategy per CBOE. It did very well for a long time since the availability of real option data in the early 1990's (various people have synthesized what index option prices *should* have been going back many decades but obviously there's a tradeoff there between bigger sample and certainty the data is worthwhile). Return was higher than the S&P IIRC into the 2010's (it should be lower, because the risk is lower), and Sharpe Ratio might still be higher inception to date. But as they say 'you can't eat Sharpe Ratio', or less flippantly the value of high SR depends on confidence to leverage up something with lower expected return but higher SR. Anyway Putwrite and tail hedging would not be contradictory, but complimentary. If you concluded Putwrite would continue to have superior SR, you might gain the confidence to leverage it up by also having tail hedges. Again just because your tail hedges are SPX puts doesn't mean you believe in a negative VRP.

*at least sketchily outlined in publicly available papers though with the usual caveat 'if you invest with us we'll do propriety versions of this general idea which are better but we won't specify details for free'.
That is kind of accurate but misses the reason altogether of the position. If you look at the delta, tail hedges often decrease that delta. You are correct in that delta has been decreased and 100% stocks is like 60/40 with the hedge (given a -40 delta hedge). However, you miss the point of the position; the position is both positively risk skewed with returns and convex.

To illustrate, let us look at the comparison of a -40 delta put option with 100% stocks versus 60/40. Same delta initially. For the hedged equity to outperform 60/40; stocks either have to move up or down a lot quickly. The traditional breaking even point for the put option on the downside is not enough to ensure outperformance; we have to pass it considerably so that the losses on the 60/40 is greater than for the hedged equity. However, the upside of the hedged equity could outperform the 60/40.

Suppose the put was 2.5% and the drop to reach the put was 2%. Maximum loss on the downside is 4.5% for the hedged equity. For 60/40 then to underperform on the down side, we would need to sustain an 7.5% drop or more on the price. On the flip side, the loss on the upside is 2.5% for the hedged equity. For the 60/40 to underperform, the price would need to rise 6.25% or more. It could be 40% chance that the hedged equity would outpeform the 60/40 (with the chance of unlikely major outperformance). However, it is likely that losses of non-trivial amounts will occur.

These are rough numbers, but the point remains that hedged equity does behave differently than a simple 60/40.
I didn't say 'the 100% equity with tail hedges will mimic 60/40 in all outcomes' which seems to be the main point you're arguing against. Nor is there any implication that the tail hedge options would have anything like 40% delta. I was deliberately staying out of the weeds of the exact specification of the hedges, but if there was a 'standard' it would be something more like 25% *out of the money*. As a real world example the net delta of my ladder of SPX/XSP puts (hedging only part not all my equity, and which includes long and short puts, but again let's stay out of the weeds before agreeing first principals) is around 6% right now.

My basic statement is not missing anything IMO, let alone missing anything altogether. Step 1 in the process, before Options 101 pay off diagrams, or a more advanced debate about how to actually do this optimally, is to realize why it might make sense to tail hedge. It's because elimination of some narrow part of the negative tail will allow you to shift some assets from lower risk to stocks. The rational* reason to not just do 100% (or more) stocks without hedges is that negative tail. One way to cushion the tail is have 40% (or whatever) in safe assets. Another is put on hedges (with no rule saying you can't do a combination of the two). So the proper comparison is of outcomes with one way of cushioning vs another way, it's not to look at the tail hedges and say 'those have negative expected return, why would I do that?' as often seems to be the case. Just like it doesn't make sense to look at the yield of bonds and say 'that's far below my estimate of expected return of stocks, why would I do that?'.

Again I am not implying that the payoff diagram of tailed hedged equity mimics that of 60/40, I'm assuming everyone at least knows the first few pages of Options 101. In the rare case where everything goes to hell the tail hedges make the near 100%/hedged portfolio comparably tolerable to the hedger as the portfolio they'd choose without any hedges, perhaps 60/40 but that's just an example. In a broad band of moderate down to mediocre up scenario's for stocks 60/40 will win because the drag of the net negative expected return of the puts will be more than the return loss from deploying the 40% to bonds. In another broad band of good>great outcomes for stocks (near) 100% tailed hedged equity will win over 60/40. There's no simple example which shows the size of those two ranges, and it also a preference issue. The first point for people to agree on though is that tail hedging is an alternative to tying up more money in low yielding safe assets, and that's what it should be compared to, though 'compared to' does not imply the payoff diagrams are the same.

*I limit my unhedged exposure to the stock market because I believe it could just crater and not come back for a long time. I don't think that likely, but it's why I limit my equity allocation, not fear of my own irrational actions in response to 'turbulence' in a stock market that 'always bounces back'.
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Re: Capturing the Volatility Risk Premium

Post by secondopinion »

JackoC wrote: Sat Oct 16, 2021 3:30 pm
secondopinion wrote: Sat Oct 16, 2021 12:47 pm
JackoC wrote: Sat Oct 16, 2021 8:31 am
FiveFactor wrote: Sat Oct 16, 2021 7:33 am
Forester wrote: Sat Oct 16, 2021 7:03 am So we have one camp touting the Volatility Risk Premium, scalping pennies from left tail insurers, then another camp (Spitznagel etc) who claim/are able to provide deep crash protection with minimal bleed.

I don't see how both approaches can profit consistently and at scale but that's my uneducated gut feel take.
Doesn’t sound to me like Spitzagel is claiming to consistently profit. More like minimize the cost of insurance for left tail…. Unless there is a paper?

Edit: and in this case both strategies are viable depending on individual portfolio needs
I agree it might seem on the surface that the two ideas are necessarily opposed but are not. Mainly because tail hedging with stock index puts, of which Spitznagel's particular approach* is just one of numerous variations, is not based on supposing a negative volatility risk premium. The simple explanation of how tail hedging can 'win' is if it allows you to maintain a higher allocation to tail hedged equities than you'd be willing to have without tail hedges. Looking for 'profit' in the tail hedges themselves is basically off track. As whenever this comes up I'll repeat, if you're willing to be 100% equities and not willing to leverage, there is no reason to tail hedge. The potential tail hedger is somebody only willing to be, for example, 60/40 without tail hedges, if tail hedging would make them accept, say, 100% equity with tail hedges. And if you look at sales stuff from Universa (Spitznagel's outfit) that's the comparison, which is conceptually the right one.

The classic example of vol risk premium harvesting is Putwrite, easy to look up the results of that strategy per CBOE. It did very well for a long time since the availability of real option data in the early 1990's (various people have synthesized what index option prices *should* have been going back many decades but obviously there's a tradeoff there between bigger sample and certainty the data is worthwhile). Return was higher than the S&P IIRC into the 2010's (it should be lower, because the risk is lower), and Sharpe Ratio might still be higher inception to date. But as they say 'you can't eat Sharpe Ratio', or less flippantly the value of high SR depends on confidence to leverage up something with lower expected return but higher SR. Anyway Putwrite and tail hedging would not be contradictory, but complimentary. If you concluded Putwrite would continue to have superior SR, you might gain the confidence to leverage it up by also having tail hedges. Again just because your tail hedges are SPX puts doesn't mean you believe in a negative VRP.

*at least sketchily outlined in publicly available papers though with the usual caveat 'if you invest with us we'll do propriety versions of this general idea which are better but we won't specify details for free'.
That is kind of accurate but misses the reason altogether of the position. If you look at the delta, tail hedges often decrease that delta. You are correct in that delta has been decreased and 100% stocks is like 60/40 with the hedge (given a -40 delta hedge). However, you miss the point of the position; the position is both positively risk skewed with returns and convex.

To illustrate, let us look at the comparison of a -40 delta put option with 100% stocks versus 60/40. Same delta initially. For the hedged equity to outperform 60/40; stocks either have to move up or down a lot quickly. The traditional breaking even point for the put option on the downside is not enough to ensure outperformance; we have to pass it considerably so that the losses on the 60/40 is greater than for the hedged equity. However, the upside of the hedged equity could outperform the 60/40.

Suppose the put was 2.5% and the drop to reach the put was 2%. Maximum loss on the downside is 4.5% for the hedged equity. For 60/40 then to underperform on the down side, we would need to sustain an 7.5% drop or more on the price. On the flip side, the loss on the upside is 2.5% for the hedged equity. For the 60/40 to underperform, the price would need to rise 6.25% or more. It could be 40% chance that the hedged equity would outpeform the 60/40 (with the chance of unlikely major outperformance). However, it is likely that losses of non-trivial amounts will occur.

These are rough numbers, but the point remains that hedged equity does behave differently than a simple 60/40.
I didn't say 'the 100% equity with tail hedges will mimic 60/40 in all outcomes' which seems to be the main point you're arguing against. Nor is there any implication that the tail hedge options would have anything like 40% delta. I was deliberately staying out of the weeds of the exact specification of the hedges, but if there was a 'standard' it would be something more like 25% *out of the money*. As a real world example the net delta of my ladder of SPX/XSP puts (hedging only part not all my equity, and which includes long and short puts, but again let's stay out of the weeds before agreeing first principals) is around 6% right now.

My basic statement is not missing anything IMO, let alone missing anything altogether. Step 1 in the process, before Options 101 pay off diagrams, or a more advanced debate about how to actually do this optimally, is to realize why it might make sense to tail hedge. It's because elimination of the some narrow part of the negative tail will allow you to shift some assets from lower risk to stocks. The rational* reason to not just do 100% (or more) stocks without hedges is that negative tail. One way to cushion the tail is have 40% (or whatever) in safe assets. Another is put on hedges (with no rule saying you can't do a combination of the two). So the proper comparison is of outcomes with one way of cushioning vs another way, it's not to look at the tail hedges and say 'those have negative expected return, why would I do that?' as often seems to be the case. Just like it doesn't make sense to look at the yield of bonds and say 'that's far below my estimate of expected return of stocks, why would I do that?'.

Again I am not implying that the payoff diagram of tailed hedged equity mimics that of 60/40, I'm assuming everyone at least knows the first few pages of Options 101. In the rare case where everything goes to [heck] the tail hedges make the near 100%/hedged portfolio comparably tolerable to the hedger as the portfolio they'd choose without any hedges, perhaps 60/40 but that's just an example. In a broad band of moderate down to mediocre up scenario's for stocks 60/40 will win because the drag of the net negative expected return of the puts will be more than the return loss from deploying the 40% to bonds. In another broad band of good>great outcomes for stocks (near) 100% tailed hedged equity will win over 60/40. There's no simple example which shows the size of those two ranges, and it also a preference issue. The first point for people to agree on though is that tail hedging is an alternative to tying up more money in low yielding safe assets, and that's what it should be compared to, though 'compared to' does not imply the payoff diagrams are the same.

*I limit my unhedged exposure to the stock market because I believe it could just crater and not come back for a long time. That's not likely, but it's why I limit my equity allocation, not fear of my own irrational actions in response to 'turbulence' in a stock market that 'always bounces back'.
I know the 60/40 is only an example. I am just saying that comparing 60/40 and 100 with -40 delta put options is not apples to apples in the slightest due to the considerable positive risk skew carried by one and not by the other (mathematical finance says yes they are, but that is only in the moment as it constantly changes). You might know this, but I am not sure that every reader sees it that way.

I do not see it as a replacement of holding safe assets to hold hedged equity. Same as I do not see holding safe assets and writing put options to be a replacement of equity. The skew makes the analysis not addressable in the typical expected return/volatility format.
Passive investing: not about making big bucks but making profits. Active investing: not about beating the market but meeting goals. Speculation: not about timing the market but taking profitable risks.
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FiveFactor
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Re: Capturing the Volatility Risk Premium

Post by FiveFactor »

secondopinion wrote: Sat Oct 16, 2021 3:29 pm
FiveFactor wrote: Sat Oct 16, 2021 2:58 pm
secondopinion wrote: Sat Oct 16, 2021 2:54 pm
FiveFactor wrote: Sat Oct 16, 2021 1:43 pm ^^^. Correct.

And so to capture the VRP one seems to have to be on the side of selling insurance. We can do that with cash backed puts. We can do that with covered calls. Straightforward two sided coin. The reason I like the puts it tax control.
This assumes that selling the puts is profitable. Although I think it is profitable usually, remember that the case where implied volatility goes up is usually when stock prices go down. Therefore, assuming fairness implies that a negative risk skew beyond the normal amount exists (higher likelihoods of gains, higher potential losses). But, the question remains if selling -40 delta puts gains you more than what a 40/60 would give you on average.
Yup. Shocks are bad for the strategy. Slow steady gains, very good. Over the long run it’s been a profitable strategy with lower than equity valuations. It also runs ~0.6 correlation with everything else in my portfolio.

Will eventually pair with term risk as well.
Furthermore, we need to understand that there are two risks taken by writing puts aside from the delta (market risk): the volatility risk and the gamma risk. Volatility risk is the risk that changes in volatility affect the prices of the option; gamma risk is the risk because favorable movements are not as profitable as unfavorable are unprofitable when prices changes. A volatility risk premium may exist, but that is supposing that volatility is priced too much into options. That might be true; but then again, is volatility risk negatively skewed (usually slightly overpriced, but majorly underpriced in infrequent cases)? Market risk behaves that way (hence why bears are quicker to destroy than bulls are to build). Also, gamma risk I think is already negatively skewed by definition. Then again, are there vomma, gamma of gamma, and other higher degree risk premiums?

Maybe too much to worry about, but it is definitely not the expected returns/volatility analysis that the Sharpe ratio only considers.
So two points. The research into VRP suggests that implied vol runs under realized vol over time. Except in left tail events mostly.

I wish I could post pictures. The correlation map w/ my portfolio is a thing of beauty
Small/Value/Profitability: | 30% AVUV | 30% AVDV | 30% AVES | Momentum: | 5% QMOM | 5% IMOM | Volatility: | 0.1% PUTW | Term: | 0.1% BND
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nisiprius
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Re: Capturing the Volatility Risk Premium

Post by nisiprius »

FiveFactor wrote: Sat Oct 16, 2021 4:10 pmI wish I could post pictures. The correlation map w/ my portfolio is a thing of beauty
The admins have disabled direct posting of images in phpBB. I find that very inconvenient, but they think that Bogleheads could be at legal risk if someone posted inappropriate content and the content was physically hosted on their system. So the only way to post pictures is to use an image hosting service, so that the actual image file is hosted elsewhere.

I obtain an image, possibly by taking a screenshot.

I go to a free image hosting site, http://www.imgur.com . I can't vouch for its security or safety. It's not a perfectly dependable site, sometimes there are errors on uploads. I established a no-cost account and I think it is slightly more dependable when I am logged into my account.

I click "new post."

I usually click "choose photo/video" which evokes a standard "file open" dialog, and I choose the file I want to upload. I don't know the full list of formats that are supported, but definitely .png and .jpg

The image uploads and is displayed.

Image

Now, there are a variety of things to do, but this is what I do. I click on "copy link." I paste it into the edit window, flanked by "img" tags, e.g.

Code: Select all

[img]https://imgur.com/NlYoZRA.png[/img]
But I'm not done yet. To make the link valid it's necessary to follow it with the file extension; I don't know why imgur doesn't do this for me. I know whether it is a .png or a .jpg file, and I type in the correct extension, e.g.

Code: Select all

[img]https://imgur.com/NlYoZRA.png[/img]
And the result, when previewed or posted, is:

Image
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
JackoC
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Re: Capturing the Volatility Risk Premium

Post by JackoC »

secondopinion wrote: Sat Oct 16, 2021 4:00 pm
JackoC wrote: Sat Oct 16, 2021 3:30 pm
secondopinion wrote: Sat Oct 16, 2021 12:47 pm
JackoC wrote: Sat Oct 16, 2021 8:31 am
FiveFactor wrote: Sat Oct 16, 2021 7:33 am Doesn’t sound to me like Spitzagel is claiming to consistently profit. More like minimize the cost of insurance for left tail…. Unless there is a paper?
I agree it might seem on the surface that the two ideas are necessarily opposed but are not.
That is kind of accurate but misses the reason altogether of the position.
I didn't say 'the 100% equity with tail hedges will mimic 60/40 in all outcomes' which seems to be the main point you're arguing against. Nor is there any implication that the tail hedge options would have anything like 40% delta. I was deliberately staying out of the weeds of the exact specification of the hedges, but if there was a 'standard' it would be something more like 25% *out of the money*. As a real world example the net delta of my ladder of SPX/XSP puts (hedging only part not all my equity, and which includes long and short puts, but again let's stay out of the weeds before agreeing first principals) is around 6% right now.

My basic statement is not missing anything IMO, let alone missing anything altogether. ... The first point for people to agree on though is that tail hedging is an alternative to tying up more money in low yielding safe assets, and that's what it should be compared to, though 'compared to' does not imply the payoff diagrams are the same.
1. I know the 60/40 is only an example. I am just saying that comparing 60/40 and 100 with -40 delta put options is not apples to apples in the slightest due to the considerable positive risk skew carried by one and not by the other (mathematical finance says yes they are, but that is only in the moment as it constantly changes). You might know this, but I am not sure that every reader sees it that way.

2. I do not see it as a replacement of holding safe assets to hold hedged equity. Same as I do not see holding safe assets and writing put options to be a replacement of equity. The skew makes the analysis not addressable in the typical expected return/volatility format.
1. I refer you to the bolded part of my last response. I never wrote a word about a portfolio of 100% stock hedged with 40% delta puts, that's entirely by you. The tail hedge portfolio is constructed to make the losses of (near) 100% equity w/ tail hedge comparable to those of a mixed stock/bond portfolio, say 60/40 in the scenario(s) which would make the investor refuse to go above 60 if they had no hedges. Mine comes out at notionally 25% below the money (sometimes less depending the available strikes at the maturities I want and according to further details how to minimize cost which is beyond scope if we're disagreeing about stuff as basic as we are). That's pretty typical in the literature. The delta position is ignored because there is no hedging of the options. The 'positive skew' is simply truncation of the far negative tail of stock return when the option ends up in the money, the whole idea of doing it. Truncating that tail allows me to maintain a higher risk asset allocation than if I didn't, according to my risk preference. It's perhaps simpler than you seem to imagine, again at least the basic reason why.

2. Whether one chooses it (hedged equity) in whole or part as substitute is again a preference issue. Nobody said one is an exact replica of another, another theme based on nothing I ever said. But if an investor is a 'nervous bull', generally expecting good stock market returns but unwilling to risk the negative tail outcome at 100% equity unhedged so would choose a lower one, hedges can allow the allocation be raised to 100 (or partial hedges to raise it from 60 to 70 or whatever the case may be). But the key point, while again *not* claiming that near 100% hedged equity has the similar returns in all cases to 60/40, is that it is a different way to cushion downside, the same basic reason you'd have low risk assets. Therefore it makes no more sense to write off tail hedging categorically by claiming the expected return of the puts is negative (in the simple case it will generally be, further in the weeds we could discuss strategies where it might be positive with less protection in some cases, no free lunch) than it is to write off being 60/40 rather than 100% stock (unhedged) because bonds yield is negative relative to stock expected return.

Just safe assets and *selling* comparably *below the money* puts implies implies leverage to get significant return and delta hedging if risk would be limited to anything sane, still loads of risk with delta hedging it when realized vol explodes. That's not only the other way around from tail hedging, it's a pretty different discussion than Putwrite where the straight index is selling *non levered* ATM puts. Putwrite is *less* negatively skewed than SPY, though it should also have lower return. But 100% Putwrite could be a plausible substitute for 60/40 depending on preference and outlook for the VRP on *ATM* options. It's not true that it doesn't fit into the same risk/return framework, but again there's no implication in that statement that it has the exact same payoffs as 60/40. But Putwrite has unfavorable tax treatment, and AFAIK I know it's now hard to do in an IRA (I used to do it in IRA at IBKR, but they changed their margin requirements on sold puts on stock index futures in IRA, the instrument I used, from generous to onerous, some years ago).
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Re: Capturing the Volatility Risk Premium

Post by FiveFactor »

Updated sig
Small/Value/Profitability: | 30% AVUV | 30% AVDV | 30% AVES | Momentum: | 5% QMOM | 5% IMOM | Volatility: | 0.1% PUTW | Term: | 0.1% BND
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Re: Capturing the Volatility Risk Premium

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We believe that in the case of financial insurance, investor demand for and value placed on such insurance is underpinned by risk aversion and the tendency to overestimate the probability of extreme market events.
Personally I lean more to the 'black swan' camp that moderately to deeply OTM puts are probably underpriced. Their study about crash expectations being wrong over the last 20 years doesn't tell us much about the likelihood of future events, especially those that are likely to be harmful to other parts of your portfolio at the same time.
For the period 1996 to 2016, we construct a hypothetical portfolio that is long the S&P 500 and a continuously rolled one-month, 5% out-of-the-money “protective put” to hedge against losses.
I'm not sure studying 5% OTM puts over a 20 year period really says much of anything about a broader range of strikes and market environments.

The fact that the fund created by the firm which published this paper had to be liquidated should really be a bright red warning light.

FiveFactor, why do you think you should put yourself in the position of selling insurance? Why is that a better vol play than just holding the underlying?
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Re: Capturing the Volatility Risk Premium

Post by secondopinion »

000 wrote: Sat Oct 16, 2021 9:19 pm
We believe that in the case of financial insurance, investor demand for and value placed on such insurance is underpinned by risk aversion and the tendency to overestimate the probability of extreme market events.
Personally I lean more to the 'black swan' camp that moderately to deeply OTM puts are probably underpriced. Their study about crash expectations being wrong over the last 20 years doesn't tell us much about the likelihood of future events, especially those that are likely to be harmful to other parts of your portfolio at the same time.
For the period 1996 to 2016, we construct a hypothetical portfolio that is long the S&P 500 and a continuously rolled one-month, 5% out-of-the-money “protective put” to hedge against losses.
I'm not sure studying 5% OTM puts over a 20 year period really says much of anything about a broader range of strikes and market environments.

The fact that the fund created by the firm which published this paper had to be liquidated should really be a bright red warning light.

FiveFactor, why do you think you should put yourself in the position of selling insurance? Why is that a better vol play than just holding the underlying?
Negative risk skew: taking likely outperformance for possible unlikely major underperformance. If the put writing is done backed with safe assets, then it is safer than holding the underlying. But there is a real question as to whether the likely gains are masking the real risks and real expected returns. It is not solely a volatility play.

I am in the camp that pricing is rather fairly done (I lean towards the put writers having the positive expected return, but that is because I assume there is a reasonable equity premium for taking positive delta on market risk). Puts are "expensive" when they are out of the money because movement downward usually implies an increase in volatility; a double benefit from holding the put, and so puts can potentially be really profitable. However, the usual case is upward movement for stocks and skews not favoring the bought put options; so, it is more unlikely than naive analysis suggests for a bought put option to be profitable.
Passive investing: not about making big bucks but making profits. Active investing: not about beating the market but meeting goals. Speculation: not about timing the market but taking profitable risks.
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Re: Capturing the Volatility Risk Premium

Post by 000 »

secondopinion wrote: Sun Oct 17, 2021 12:21 am Negative risk skew: taking likely outperformance for possible unlikely major underperformance. If the put writing is done backed with safe assets, then it is safer than holding the underlying. But there is a real question as to whether the likely gains are masking the real risks and real expected returns. It is not solely a volatility play.

I am in the camp that pricing is rather fairly done (I lean towards the put writers having the positive expected return, but that is because I assume there is a reasonable equity premium for taking positive delta on market risk). Puts are "expensive" when they are out of the money because movement downward usually implies an increase in volatility; a double benefit from holding the put, and so puts can potentially be really profitable. However, the usual case is upward movement for stocks and skews not favoring the bought put options; so, it is more unlikely than naive analysis suggests for a bought put option to be profitable.
Yes a passive investor should probably assume that liquid instruments including listed options with active volume are fairly priced.

One thing that I find interesting about strategies like this / funds discussed in this thread is they seem to be kind of a passive-active hybrid and may very well be getting the worst of both worlds. Their trading costs and manager involvement in implementation may neuter typical passive advantages while the attempt to be rules-based may constrain the fund to inefficacy. This may offer a partial explanation to the failure and fund closure of these kind of alt strategies.
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Re: Capturing the Volatility Risk Premium

Post by nisiprius »

FiveFactor wrote: Sat Oct 16, 2021 6:07 pm Updated sig:

Small/Value/Profitability: | 30% AVUV | 30% AVDV | 30% AVES | Momentum: | 5% QMOM | 5% IMOM | Volatility: | 0.1% PUTW | Term: | 0.1% BND
???? Is that an actual portfolio? Do you actually have 0.1% allocations to PUTW and BND? Do you actually have 30% of your portfolio allocated to AVES, nineteen days since inception on 09/28/2021?
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
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Re: Capturing the Volatility Risk Premium

Post by FiveFactor »

nisiprius wrote: Sun Oct 17, 2021 5:42 am
FiveFactor wrote: Sat Oct 16, 2021 6:07 pm Updated sig:

Small/Value/Profitability: | 30% AVUV | 30% AVDV | 30% AVES | Momentum: | 5% QMOM | 5% IMOM | Volatility: | 0.1% PUTW | Term: | 0.1% BND
???? Is that an actual portfolio? Do you actually have 0.1% allocations to PUTW and BND? Do you actually have 30% of your portfolio allocated to AVES, nineteen days since inception on 09/28/2021?
Omg do you actually concentrate all your equity risk on a single factor?

Yes. That is accurate. 1 share each of PUTW and BND as placeholders. It’s also a 7-figure portfolio. You have an issue with my choices?
Small/Value/Profitability: | 30% AVUV | 30% AVDV | 30% AVES | Momentum: | 5% QMOM | 5% IMOM | Volatility: | 0.1% PUTW | Term: | 0.1% BND
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Re: Capturing the Volatility Risk Premium

Post by nisiprius »

FiveFactor wrote: Sun Oct 17, 2021 5:55 am
nisiprius wrote: Sun Oct 17, 2021 5:42 am
FiveFactor wrote: Sat Oct 16, 2021 6:07 pm Updated sig:

Small/Value/Profitability: | 30% AVUV | 30% AVDV | 30% AVES | Momentum: | 5% QMOM | 5% IMOM | Volatility: | 0.1% PUTW | Term: | 0.1% BND
???? Is that an actual portfolio? Do you actually have 0.1% allocations to PUTW and BND? Do you actually have 30% of your portfolio allocated to AVES, nineteen days since inception on 09/28/2021?
Omg do you actually concentrate all your equity risk on a single factor?

Yes. That is accurate. 1 share each of PUTW and BND as placeholders. It’s also a 7-figure portfolio. You have an issue with my choices?
Not really. I don't have an "issue" with the "placeholders," but I don't understand what they are there for.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
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Re: Capturing the Volatility Risk Premium

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nisiprius wrote: Sun Oct 17, 2021 6:11 amNot really. I don't have an "issue" with the "placeholders," but I don't understand what they are there for.
It’s 1 share of each. $120. They are there so I have all the components of my terminal portfolio in place. I’m almost done contributing to SV. Will top off momentum. Then on to volatility then term.

Eventually I’ll get to my retirement allocation
Small/Value/Profitability: | 30% AVUV | 30% AVDV | 30% AVES | Momentum: | 5% QMOM | 5% IMOM | Volatility: | 0.1% PUTW | Term: | 0.1% BND
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Re: Capturing the Volatility Risk Premium

Post by nisiprius »

Got it. Most important first. And the final target is to have more in QMOM and IMOM than you do now, as well as meaningful holdings of PUTW and BND. Is the final target equal amounts, 20% each? :oops: 1/7th each? Just curious, no criticism implied.
Last edited by nisiprius on Sun Oct 17, 2021 10:18 am, edited 1 time in total.
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Re: Capturing the Volatility Risk Premium

Post by FiveFactor »

nisiprius wrote: Sun Oct 17, 2021 8:09 am Got it. Most important first. And the final target is to have more in QMOM and IMOM than you do now, as well as meaningful holdings of PUTW and BND. Is the final target equal amounts, 20% each? Just curious, no criticism implied.
I think of it in terms of phasing. Ideally I will be around:

15% AVUV (DFSVX)
15% AVDV (DFIVX)
15% AVES (DFEVX)
15% QMOM
15% IMOM
15% PUTW
10% BND (or EDV)

You can backtest with the DFA equivalent noted. I also keep 1 year expenses in cash. Goal is to eventually have 7-10 years in cash/BND.

Before Jan 2020 I was 75% VT, 25% VBR. I moved all in on SV on 3/23/2020. I saw the opportunity to complete my contributions the most volatile part of my portfolio at the time its at its relative cheapest ever. Then I added momentum to balance some of the volatility. VRP and Term risk are two more layers planned.
Small/Value/Profitability: | 30% AVUV | 30% AVDV | 30% AVES | Momentum: | 5% QMOM | 5% IMOM | Volatility: | 0.1% PUTW | Term: | 0.1% BND
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Re: Capturing the Volatility Risk Premium

Post by JackoC »

000 wrote: Sat Oct 16, 2021 9:19 pm
For the period 1996 to 2016, we construct a hypothetical portfolio that is long the S&P 500 and a continuously rolled one-month, 5% out-of-the-money “protective put” to hedge against losses.
1. I'm not sure studying 5% OTM puts over a 20 year period really says much of anything about a broader range of strikes and market environments.

2. The fact that the fund created by the firm which published this paper had to be liquidated should really be a bright red warning light.
1. Yes, different strategies under this general heading have dramatically different past results. That's not really too surprising, would we expect the history of buying 25% OTM puts to really be similar to 5% OTM? But I think most of those in favor of the general concept would view 5% OTM continuously rolling one month as cherry picking something which has tended not to work. In some other threads here the Artemis 'Dragon Portfolio' has been discussed. That firm presents results going back around 100 yrs* where the 25% component of the portfolio 'long volatility' was buying 5% OTM rolling one month puts, but only when the market was in a downtrend specified by a rule (and 5% OTOM calls were bought when the market was trending up). Spitznagel/Universa was mentioned, his papers condemn continuous near money puts as not the way to do it. His general idea insofar as he gives any specifics in the public papers, is buying much further OTM, 25-30%, 2 month puts and replacing them at 1 month to maturity. Also at least in theory Spitznagel says to tail hedge only when market valuation (per Tobin Q) is in the upper quartile of long history...but it almost always has been since Universa's been around. Another dimension is maturity of the puts which also matters in terms of historical result. Bhansali's book "Tail Risk Hedging" mainly deals in examples of 1 yr puts with 25% OTM being again a common benchmark. The book explores a number of strategies that may reduce cost ('monetizing', where you sell the puts before maturity and replace with lower strike if the put price has reached X times what you paid; 'indirect' where you replicate the far OTM put, under certain assumptions, with a smaller put spread of long ATM/ short OTM when the vol skew is especially high, etc). Some of those back test to positive expected return for the puts, but once again at the risk of redundancy the feasibility of tail hedging does not hinge on the puts making money, unless you're indifferent to risk. For those with risk aversion the idea is to allow a higher allocation to equities than you could tolerate without protection from the left tail. For those willing to tolerate the unhedged return of 100% equity but who also impose on themselves the arbitrary limit of no leverage, there is no reason to consider tail hedging.

2. I'm not sure the significance of that for the broad topic. The people assuming it has great significance in many cases are against 'complicated' things from the get go (and simplicity does have it's advantages there's no question, but it's not always the answer, in investing or life in general) and would not be any more inclined to the general idea if that particular fund hadn't shut down.

*synthesizing what S&P index option prices would have been decades before they existed based on the relationship of later known option prices to various regression variables. That's not as flaky as it sounds, since different researchers have done that with different methods but come up with relatively similar answers, but it's obviously still subject to uncertainty.
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Re: Capturing the Volatility Risk Premium

Post by 000 »

JackoC wrote: Sun Oct 17, 2021 12:10 pm 2. I'm not sure the significance of that for the broad topic. The people assuming it has great significance in many cases are against 'complicated' things from the get go (and simplicity does have it's advantages there's no question, but it's not always the answer, in investing or life in general) and would not be any more inclined to the general idea if that particular fund hadn't shut down.
I would say it is significant for investors getting access to the strategy via a fund instead of doing their own options trades. Several alt funds (some mentioned above) have closed within a few years of inception leaving normal investors no way to stay the course (because most normal investors don't know how to implement these strategies on their own and there may not be a substitute fund available).
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Re: Capturing the Volatility Risk Premium

Post by JackoC »

000 wrote: Sun Oct 17, 2021 4:28 pm
JackoC wrote: Sun Oct 17, 2021 12:10 pm 2. I'm not sure the significance of that for the broad topic. The people assuming it has great significance in many cases are against 'complicated' things from the get go (and simplicity does have it's advantages there's no question, but it's not always the answer, in investing or life in general) and would not be any more inclined to the general idea if that particular fund hadn't shut down.
I would say it is significant for investors getting access to the strategy via a fund instead of doing their own options trades. Several alt funds (some mentioned above) have closed within a few years of inception leaving normal investors no way to stay the course (because most normal investors don't know how to implement these strategies on their own and there may not be a substitute fund available).
My own view would be that if you don't understand stuff like this enough to do it yourself, that's at least an orange light about doing it via a fund. Although there could be exceptions to that. But also there are a lot of ideas which work, but the net improvement they give you, if you could distill it down to a spread by which you were 'net better off, risk adjusted' would be relatively small. You don't really expect to find fairly simple things that make you 1-2% pa net better off every year forever, some 0.1%'s net better off is more plausible. In which case the expenses of 'idea' funds can loom large even if not extremely high. And as a related point, if something proves over a time a reasonably good idea, it's still not likely to *always* work so if a fund closes because it can't attract enough investors to be a money maker for the sponsor, perhaps in part because the idea hasn't worked as well for a few years as it did in the back tests, that doesn't necessarily prove anything about the idea as opposed to impatience of the target audience.

But basically I'd reiterate my last point the first time around. If the fund hadn't closed, would some people here with no interest in actually delving into the topic of tail hedging be a lot more interested in delving into with actually open minds? I doubt it. I could be wrong, but it's the impression I have of some frequent posters here.

And my bottom line would remain that whether some AQR fund closed down would have zero impact on my view of a particular tail hedging strategy I might pursue that's different from the one in the AQR fund.
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