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Showing posts from June, 2017

The Variance Premium in Commodity Markets

There is an old option trader saying (actually it is possible I made it up, but I’m pretty old), “Equities trade based on statistics. Commodities trade based on knowledge.” This means that if you can successfully trade options on MSFT, you will probably also do OK trading options on any number of other equities. Indeed, most professional equity option traders routinely trade 50-100 different names. Commodities aren’t like this. A good bean trader can’t just start trading corn and expect to be successful. The knowledge of the crop just isn’t directly transferable.
So I’ve always been suspicious of commodities. I don’t like trading something where product specific knowledge is important. I’m never going to be the knowledgeable one in these products. But it is always good to look for new edges so, after some prodding from a couple of readers, I decided to take another look at commodity options. Specifically, is there a persistent variance premium?

The paper,” Variance Risk Premia in Com…

Variations of Volatility

In the last entry I showed that adding volatility to a typical equity/bond portfolio makes it better. Feel free to define better however you like (lower volatility, higher Sharpe ratio, lower drawdowns…): a volatility position makes things better.
But the example I gave understates the case. There are several ways to trade volatility and they aren’t as correlated as people think. So instead of just adding one type of volatility we should add two.

The first way is to trade implied volatility. This can be done by trading VIX futures, VSTOXX futures and the various volatility ETNs. This was the example I used previously. In Figure One I show the results of buying XIV (the VelocityShares Daily Inverse VIX Short Term ETN) in 2016. 

Figure One: The growth of $100 when buying XIV.
Return: 81.2% Volatility: 66.6% Maximum drawdown: 38% Sharpe Ratio: 1.3
The other way to get volatility exposure is to trade realized volatility by trading equity options and hedging appropriately. The details of …

The Missing Link

Most well-read investors are aware of the need to hold both bonds and equities in their portfolio. Even though these instruments often have correlated returns, the diversification benefit and the periodic boost through active rebalancing still mean a stock/bond portfolio is better than stocks alone. “Better” can be measured in many ways but we can keep it simple.
Since June of 2004 (a starting period that will make sense later): ·A 60/40 mix of equity and bonds had an average annualized return of 10.6% and annualized volatility of 11.0%. Maximum drawdown was 36.8%.
·The S&P 500 (including dividends) had an average annualized return of 7.6% and annualized volatility of 19.4%. Maximum drawdown was 56.8%.
This is a decisive victory for the idea of a portfolio over just equities. This idea can be extended to other asset classes as well. For example, we could include commodities and real estate. But in the last few decades several products have been developed that depend in some way on …