High Probability Options Strategy (HIPOS): Why Conservative Posture?
Recently we’ve been getting a lot of questions about any inherent risks with the VIX hitting 23 year lows. And while the questions range from, “Is now the time to get long volatility while its cheap?” or “Is this a signal of impending doom?”, the theme always comes back to how does it affect our HiPOS Strategy.
Back in November 2015 we observed and analyzed a change in the volatility market and adopted a more conservative posture for our HiPOS accounts. We thought we’d share that explanation that we recently shared with a client on the subject.
Why take a conservative posture?
It starts with defining the strategy as a “short volatility” strategy. As net sellers of premium we benefit from time decay and volatility staying rangebound. Conversely, when we are in a spread position, we are vulnerable to spikes in volatility. To keep things simple, we’ll use the VIX as the measure of 30-day implied volatility. As you know, the VIX typically moves up when the market drops. And when the market drops rapidly, the VIX has dramatic spikes.
Historically speaking, the movement of the VIX to the S&P 500 has been about 5 to -1. Said another way, when the S&P dropped 1% in a single day, the VIX would move higher by 5%. However, since late 2014, that ratio has been increasing and in the last 12 months has moved to nearly an 8.5 to -1 ratio. As a reminder, our real risk is spiking volatility, not so much a drop in the market. So due to the change in the ratio when faced with regular/normal market movements, the strategy has an increased chance of a losing trade due to magnitude of the volatility spikes. In other words, the same market moves contain more risk.
The second data point we reviewed is how often these outsized spikes are occurring. Again, this is the primary risk of the strategy. We looked at the extremes of how often the VIX spiked 20+ times the amount of the S&P movement. That’s 4 times normal. From 2012 to 2014, a 1 to -20 ratio occurred only 2% of the time. Before that, it almost never happened. In the last 12 months that frequency has increased to 10% of the time.
So, to us even though volatility is at historic lows, we believe that the current volatility regime requires us to reduce strategy risk appropriate to the current environment.
How are you reducing risk?
We are putting on positions that are more conservative. Simply put, we are getting farther out-of-the-money on our short strikes. In the past, we’d sell puts with at least a 95% probability of expiring worthless. Currently we have moved the probability component of our calculus in qualifying trades to at least a 99% probability of expiring worthless. Remember, as sellers of spreads, ideally we want them to expire worthless to realize a full profit. Since we are selling further away spreads, our targets have also been adjusted so returns are not as high as we are taking less risk.
The results speak for themselves as this adjustment has worked for us. In early 2016 when the market sold off 12% thru mid Feb, HiPOS avoided a losing trade being conservative. We also avoided a losing trade during the short Brexit event. And finally, in late October 2016 when the market had 9 days in a row of declines, the conservative strategy kept us from a losing trade as well.
So What’s Next:
We continue to watch for a change in the VIX to S&P ratio to return to historical norms. We are always looking at any optimizations or improvements we can make to the strategy. Our process though is very calculated and methodical in maintaining a rule based strategy. A strategy such as HIPOS requires discipline. As always if anyone has questions feel free to give us a call to talk further.
For now, we will continue to monitor the market for a new trade that meets our entry criteria.