Stocks quoted in this article:
It was a tough week for the CBOE Volatility Index … but that's mainly because it had such a strong close to the week before. Remember way back then, Pi Day? We were so afraid Russia would annex Crimea that we needed portfolio protection in a big way.
You know the punch line there.
VIX dropped from 17.82 to 15 on the week, nearly 16%. Yet it's still sitting at 15, up about 9.3% in 2014 with the market up about 1%.
The other day I linked to a CBOE piece that noted that fund managers who used options managed to outperform their peers, despite the fact that they were net options sellers into a bull market. I speculated that was possible if they actively hedged their short options positions.
I worry that I made that strategy sound like the correct one. The problem is that it is only correct to actively hedge a short volatility position when the market makes a directional move. And you only know that in hindsight.
I bring that up because net options sellers are having the diametrically opposite experience in 2014. We're in total churn. If you watch the market every day with a short volatility position, you've probably gotten a little seasick. One day it's up big, another day it's down big. And implied volatility itself is relentlessly static. Any active hedger is probably getting whipsawed buying strength that peters out and selling weakness that looks like Armageddon is imminent.
The best short volatility strategy in 2014 involves doing absolutely nothing. Well, nothing beyond selling the volatility in the first place. Again, we're up all of 1% this year ... a bit more if you add in dividends. If all you did was sell options and roll a bit, you've clearly added some value. Any hedging with stock or futures probably took some of that value away.
Hedging short volatility is always a question of judgment. On each move, you have to decide whether to hedge, sit tight, or get aggressive and add on to your position (known as The Texas Hedge). I assumed that net-net, the above fund managers must have hedged aggressively in 2009-2013, otherwise it's tough to figure out how they beat the market. We won't know how they did in 2014 for a while, but it is probably safe to assume they're not whipsawing themselves so much that they've blown their added gains. After all, it's never a black or white answer -- it's always going to be a shade of gray. And at the end of the day, this year is best-case for a strategy that uses options sales to add value.
Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.