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Vol of Vol Practical thoughts on trading volatility as a distinct asset class Michael Fagan Chairman Levitas Capital Vol of Vol: 2015 some extraordinary happenings In 2015 the events of August represent an extraordinary example of the

  1. Vol of Vol Practical thoughts on trading volatility as a distinct asset class Michael Fagan Chairman Levitas Capital

  2. Vol of Vol: 2015 some extraordinary happenings • In 2015 the events of August represent an extraordinary example of the ferocity of vol of vol 2015 • This plot shows the percentage change in implied vol of VIX options against a change in the term structure of the futures • The rise in the implied vol is accompanied by some of the steepest observations of the futures curves we’ve seen since the inception of the product group • No other financial product can capture the velocity of the moves that we have so far observed 2

  3. The Volatility Dichotomy Volatility as an Volatility as a Hedge Asset Class • Agnostic to the noise of the market • Protect against macro or unforeseen events • Use statistical analysis of behavioral patterns in volatility product groups • Allows managers to “stick” to core holdings • Positioning independent of bottom-up analysis • Positive convexity is comforting • Extreme situations force abnormal • Acknowledge the power of volatility over performance results direction in certain circumstance • Cost of protection acts as a drag on • Scale volatility exposure by recognizing the various tools available to the investor performance in good times • Picking individual volatility winners is cheaper, but difficult for most fund 3 managers to achieve

  4. VIX: The Opportunity of negative correlation VIX Relationships 2008 to 2015 50.00% 40.00% SPX ASX200 30.00% FTSE 20.00% Eurostoxx 10.00% N225 0.00% Linear (SPX) -15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00% -10.00% Linear (ASX200) -20.00% Linear (FTSE) Linear (Eurostoxx) -30.00% Linear (N225) -40.00% R² = 0.5644 -50.00% The VIX and its associated derivatives provide the opportunity to capture negative correlated returns 4

  5. Vol of Vol: What does it look like to a trader? • 2008 and we enter into the Lehmans phase of the financial Largest monthly SPX fall since 2007 crisis • What works better? VIX options or SPX puts? • The initial move shows the extreme reaction of vol of vol to the events, outperforming an equivalent SPX put by a factor of 4 • Here you can see the way the Vol of Vol (represented here via the VVIX) rising, reflecting the price action we see in the VIX calls (Chart utilzes the nearest OTM options; buying second expiry month holding over 1 calendar month of interest.) 5

  6. Vol of Vol: What does it look like to a trader? • Second largest monthly SPX fall since 2007 2009 and Central Banks are injecting capital in response to the credit crisis • Equity markets decline, but VVIX declines with them • Note that the VIX and the VIX Futures remain elevated • Here you can see the way the SPX puts now out perform in response to the one way nature of the S&P 500’s movement (Chart utilzes the nearest OTM options; buying second expiry month holding over 1 calendar month of interest.) 6

  7. SPX Puts vs VIX Calls – Is there a difference? In “normal markets” VIX calls act very • much like S&P puts, i.e. excluding major market disrupTons ρ = 1.00 At the start of the ’09 recovery Vol of • Vol had to normalize, you couldn’t hold and ride the delta, you had to trade to capture the outperformance Equity hedgers will want to concentrate • on the extreme events In event of extreme outliers, VIX calls • grossly outperform S&P puts (Analysis 2007-2015, utilzing the nearest OTM options; buying second expiry month holding over 1 calendar month of interest.) 
 7

  8. SPX Puts & VIX Calls – P&L Distribution (Analysis 2007-2015, utilzing the nearest OTM options; buying second expiry month holding over 1 calendar month of interest.) 
 • Timing remains key • Systematic buying of options (SPX puts or VIX calls) is unprofitable • Losses for > 90% of the time • Ave Put Losses = -25% of premium • Ave Call Losses = -12% of premium 8

  9. Vol of Vol • VIX options are ultra sensitive to market inflexion points, more so than standard Vol instruments (e.g. SPX puts) • The market overpays for insurance for the outlier events because of this sensitivity (more on that later) • Systemic buying of options in itself produces significant drag on the portfolio of a hedger because you’re mostly losing • A trading mentality that separates the normal and the abnormal coupled with timing is a better path • Vol of Vol is more tactical than strategic 9

  10. VIX Strategy: Selling Volatility via Short Calls PnL ($ per contract) VIX Index Implied Volatility (%) Term Structure (%) PnL ($ per contract) Index/Term Structure Term Structure/Implied Volatility Statistics <19 >19 <75 >75 <9 >9 Statistics Low/Low High/High low/Low High/High Average 42.6 75.2 23.7 94.0 36.4 81.4 Average -20.6 138.7 -0.8 118.2 Median 90.0 175.0 90.0 155.0 125.0 115.0 Median 90.0 190.0 90.0 160.0 STD 247.2 496.0 407.2 372.5 487.4 261.3 STD 475.0 261.5 477.8 268.4 SKEW -3.9 -5.0 -5.9 -4.9 -5.1 -3.4 SKEW -5.2 -3.6 -5.2 -3.4 % Positve 89.1 87.8 88.3 88.7 87.5 89.5 % Positve 85.3 91.6 87.8 89.2 AVE/STD 0.17 0.15 0.06 0.25 0.07 0.31 AVE/STD -0.04 0.53 0.00 0.44 This analysis shows the P&L per contract by selling OTM calls in the front month up to 2 weeks till expiry, after which point selling the second month with positions held to expiry. 10

  11. VIX: Using Vol of Vol like an Actuary • By using statistical analysis of VIX Cash levels, Implied Vol and Term Structure to determine option positioning. We believe a successful quantitative strategy is possible with an agnostic view of price movement. • One would assume that due to VIX Cash mean reversion characteristics, selling VIX when it is high would be a successful trade. However, on an Average/Standard Deviation basis, there is no clear trade based purely on the VIX Cash level. • Positioning based on the Term Structure alone (which is often when the cash is at its lowest levels) results in double the success based on the Average/Standard Deviation of the VIX Cash level. • Combining high VIX Cash and high Term Structure achieves near double again the Average/Standard Deviation of the Term Structure alone. 11

  12. VIX Futures Term Structure Realized Volatility - 
 Hold on at the short end 12

  13. VIX Cash & Futures Term Structure: August 2015 VX3 VX2 VX1 VXX 45.00 40.00 35.00 30.00 25.00 40.00-45.00 20.00 35.00-40.00 15.00 30.00-35.00 10.00 25.00-30.00 5.00 0.00 20.00-25.00 03-Aug-15 04-Aug-15 05-Aug-15 15.00-20.00 06-Aug-15 07-Aug-15 10-Aug-15 10.00-15.00 11-Aug-15 12-Aug-15 13-Aug-15 5.00-10.00 14-Aug-15 17-Aug-15 18-Aug-15 0.00-5.00 19-Aug-15 20-Aug-15 21-Aug-15 24-Aug-15 25-Aug-15 26-Aug-15 27-Aug-15 28-Aug-15 31-Aug-15 13

  14. 70 60 50 40 20 30 10 0 VIX Cash & Futures Term Structure: 08 v 15 02-Jan-08 23-Jan-08 12-Feb-08 04-Mar-08 25-Mar-08 14-Apr-08 02-May-08 22-May-08 12-Jun-08 02-Jul-08 23-Jul-08 12-Aug-08 2008 02-Sep-08 22-Sep-08 10-Oct-08 30-Oct-08 19-Nov-08 10-Dec-08 31-Dec-08 30 20 25 15 10 5 0 02-Jan-15 22-Jan-15 10-Feb-15 02-Mar-15 19-Mar-15 08-Apr-15 27-Apr-15 14-May-15 03-Jun-15 22-Jun-15 2015 10-Jul-15 29-Jul-15 17-Aug-15 03-Sep-15 23-Sep-15 12-Oct-15 14

  15. Vol of Vol vs Vol Risk Premium Distribution • Compare the realized 1M vol of VXX (rolling 30-day VIX futures) with its • The greater risk premium in the VoV is justified by the great corresponding implied vol derived from its option price confirms similar dispersion of daily returns found in underling Vol instrument distribution of risk premium and the same median of 11% with a negative compared equity cash. skew of -1.2. • The higher risk premium combined with a lower negative • Compare the realized 1M vol of SPX with the VIX Index shows a more skew suggests selling vol of vol is superior to selling vol centred distribution and lower risk premium of 4% with larger negative skew of -2.3 15

  16. Returning to our first slide - Vol of Vol: 2008 v. 2015 • Which was a tougher environment for investment decisions, Lehmans ‘08 or 2015? • In 2015 (orange dots) the VIX market has arguably been more “dangerous” than 2008 • The three largest moves in vol of vol measured by the shift in VIX futures term structure and change in implied vol of the options there on, have taken place this year. • No other financial product can capture 24/10/08 S&P gapped down -8.3% and closed the day down -5.1%. VIX 67.8 VVIX 121 (starting from high vol levels) the velocity of the moves that we have so far observed 24/08/15 S&P gapped down -5.4% and closed the day down -4.1% VIX 28 VVIX 138 (starting from low vol levels) 16

  17. VIX: Options and context • VIX options represent the purest form of leverage to the velocity of market moves • 2015 was less expected by the markets than what occurred during 2008 as volatility was at a much lower absolute level • The gradient of the line of best fit for 2015 is as a series far stepper than that in 2008, indicating a significantly higher level of “surprise” • What we saw in August this year was a release of stored energy as multiple 24/10/08 S&P gapped down -8.3% and closed the day down -5.1%. macro factors shook markets VIX 67.8 VVIX 121 (starting from high vol levels) 24/08/15 S&P gapped down -5.4% and closed the day down -4.1% VIX 28 VVIX 138 (starting from low vol levels) 17

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