Ascent IT LLC Investment Adviser - Managed Investments

The expected volatility of the S&P500 stock market index is measured by the volatility index VIX of the CBOE. It is calculated as the implied volatility of a basket of call and put options on the S&P500 index.

In times of crisis, the volatility index VIX tends to go up. Some stock market participants try to use the VIX to hedge their portfolios.

It is not possible to invest directly in the Volatility Index VIX, but futures on the VIX are traded since 2004. Market participants can use these as stock portfolio insurance.

Futures introduce a new element in the investment equation: the presence of either contango or backwardation. Contango means that futures contracts further away in time are more expensive than closer futures contracts. Backwardation means the opposite, i.e. futures contracts further away in time are cheaper than closer futures contracts.

The graph depicts how the price of a single forward contract will behave through time in relation to the expected future price at any point time. A contract in contango will DEcrease in value until it equals the spot price of the underlying at maturity. A contract in backwardation will INcrease in value until it equals the spot price of the underlying at maturity.

Most of the time, the VIX futures market has been in contango, which means that e.g. futures contracts 2 months out are more expensive than futures contracts one month out. Market participants pay a premium for further out volatility contracts, to protect themselves against unforeseen market deterioration. The further away in the future, the more difficult it is to predict market turmoil, and the higher the need for volatility protection. This protection can be very expensive though. Regularly, the price of the second month VIX future contract has been 10% higher than the first month contract. If nothing spectacular happens, and the VIX stays roughly constant during that month, the buyer of the 2nd month VIX future loses 10%. The seller of the future would have earned 10%. A long position (buying the future) must overcome the contango price hurdle before it becomes profitable. A short position (selling the future) has an easier time becoming profitable in a contango situation.

The inverse holds in a backwardation situation, where the second month volatility future is cheaper than the first month future. This may happen after a large volatility spike, where market participants expect the volatility to decrease further out in time. As an example of a transaction in this situation: suppose the second month future is 10% cheaper than the first month future. If the market situation does not change, and the VIX stays roughly constant during that month, the buyer of the second month future VIX future would earn 10%. The seller of the future would have lost 10%. A long position (buying the future) has an easier time becoming profitable in a backwardation situation. A short position (selling the future) must overcome the backwardation price hurdle before it becomes profitable.

Since a couple of years, there are Exchange Traded Notes (ETN) and Exchange Traded Funds (ETFs) available on the stock market that invest in VIX futures, such as funds VXX, XIV, VXZ, ZIV, VIXY, SVXY and UVXY.

In our volatility trading strategy, we use proprietary indicators to determine when to go long or short volatility.

Since 2004, the average price for "volatility portfolio insurance" (contango between the first and second month VIX future) is more than 5% per month, which translates to about 80% per year. Since the VIX is a mean-reverting index, an almost constant expectation of growth is not realistic. Most of the time, money can be made selling volatility insurance. Even if we would sometimes mistime volatility spikes (for example during a sudden crisis such as the 9/11 attack), and be short volatility at the wrong time, a premium of 80% per year, provides a lot of buffer against mishaps.

This is a speculative investment strategy, and only suitable for investors who accept increased risk (including the possibility of losing the entire investment), in exchange for possible increased returns.

Our positions are often equivalent to selling volatility insurance, and one may wonder what the risk of such a strategy is.

The CBOE S&P 500 PutWrite Index represents a simple volatility insurance selling strategy. It measures the performance of a hypothetical portfolio that sells S&P 500 Index (SPX) put options against collateralized cash reserves held in a money market account.

Most of the time, the realized volatility is lower than the volatility implied by the put option prices, and a nice risk premium can be harvested. From time to time, there are large stock market corrections, and the "insurance" needs to be paid out, lowering the return of the strategy. Even after the payouts, the strategy is still profitable, as the graph below shows.

In contrast, the Ascent Volatility Trading Program relies on a different volatility insurance vehicle: it uses VIX futures, which represent a prediction of the price of S&P 500 options. The options by itself already contain a risk premium; predictions of option prices contain an even higher risk premium that can be harvested. The results of this approach are much better.

(1) Please note that in extreme market circumstances, prices may drop beyond the stop loss before a sell order gets executed. Large sudden price drops are still possible.

Technical background of the

Ascent Volatility Trading Program