HiPOS Update: Why Being in Cash Between Trades Is Normal and How to Set Expectations for a Short Volatility Strategy

By Derek Moore

Explaining Why HiPOS Conservative Sometimes Stays in Cash Between Trades

We used to always point out that HiPOS remained in cash on average 100 days a year.

Now, that average has gone down over the past few years where implied volatility was elevated, but in a typical year we’d expect to have some time between one trade expiring and the next trade being put on. When we say remain in cash, we are talking about how many days in between trades there are.

When we don’t have a trade on, the account shows a cash balance that receives sweep interest from respective brokerage firms.

That cash is ready at the moment’s notice to be deployed in a new HiPOS trade.

I mention the “moment’s notice” because sometimes a trade is available for only minutes under our strict rules. So it’s important to be able to strike while the irons are hot (yup I just used that phrase).

Even though there may be time in between trades, that cash is still in the strategy as in order to put on the next trade, it has to be there in the account.

Why Time Between Trades Has Been Extended Recently

When volatility is elevated, you probably got used to one trade expiring on a Friday and by Monday a fresh new one was already executed and shown in your clients’ accounts.

While we don’t publicly post our internal rules and calculations for our trades, some of the many parameters include the distance out of the money, time to expiration, and required return commensurate with the risk. When volatility is high, trades are plentiful to choose from that meet our criteria. When volatility is lower, sometimes it takes a longer bridge period between one trade and the next for something to qualify.

I’ll post a little more insight below for those of you who want to geek out on volatility.

Does The Market Need to Sell Off in The Near Term for a New Trade?

Not necessarily, but often we see a short-term spike in volatility when markets pull back a bit.

HiPOS is waiting to pounce on these events however fleeting they may be. Long time HiPOS users know that most of the time we sell put spreads below the market rather than call spreads above the market. The put side almost always has more embedded premium than the call side going back to 1987.

HiPOS is not a directional strategy as it systematically follows a set of rules that has the potential to do well in up, down, or sideways markets.

When we are patient more often the entry we get for trades is better for you and your clients by putting the probability for success in your favor.

Does HiPOS Still Work in Low Volatility Periods?

Yes, and if you look back at 2017, where there was what I call a volatility drought, the strategy still delivered nearly double-digit gains.

During that year there were greater gaps between trades, but there were opportunities. I probably wrote a similar story like this back then as well. Today is nothing like 2017 as the VIX Index reached single digits that year unlike our current market.

2017 is a good example of HiPOS in extremely low volatility periods.

The Higher the Implied Volatility the Higher the Expected Ranges

The option market prices option premiums based on future expectations of the likelihood an underlying asset may move above and below the current price and by how much.

Of course there are other inputs like interest rates, but if something is expected to have a probability of having a wider range, its options premium should be higher than something that is expected to be flat. When you hear someone say XYZ has an implied volatility (IV) of 20%, what does that mean?

A 20% IV is an annual expectation of a one standard deviation range above and below the market.

You remember the bell curve in school, right?

Figure 1: 30-Day Expected 1 & 2 Standard Deviation Percent Range Implied by Volatility Levels

Source: Authors Calculations

Within this graph I did a simple calculation of the 30-Day expected 1 and 2 standard deviation ranges.

You can see the x-axis plots those ranges based on an IV of 10%, 15%, 20%, and 25%. The higher the implied volatility, the greater the expected range and thus the greater the options premiums will be. You could also look at this another way.

The y-axis represents the percentage expected range.

The higher the IV is, the further away one could capture the same premium they could nearer to the underlying price when IV is lower.

The next section I’ll dive into some math, but you hopefully see the relationship between volatility and options expectations and prices.

Geek Out on Some IV Options Math

How did I calculate all this?

Easy, you just need the number of trading days in a year, the IV, and the number of days you want to calculate the expected 1 and 2 standard deviation ranges.

In 2023 there are 250 trading days.

√250=15.81 (This is the square root of time)

To figure out the rest you will take the IV / 15.81 so if IV is 25, then 25/15.81 = 1.58% expected 1-day standard deviation range.

To convert this to a 30-day range, simply take √30 * 1.58 which works out to be 5.48 * 1.58 = 8.66%

So, with IV at 25, the 1 standard deviation range is 8.66% and the 2 standard deviation range is just twice that.

Wrapping Up

Ok, no more math!

Here are the important takeaways from this state of HiPOS update.

HiPOS Conservative Historically Has Remained in Cash for Some Time Between Trades
When volatility is higher, there tends to be less or no time between trades.
When volatility is lower, accounts will be preparing for the next trade and sit in cash.
Cash in HiPOS accounts is the collateral needed to hold short spreads in the accounts.
HiPOS historically has shown the ability to work in a variety of markets.
ZEGA monitors markets waiting to pounce on opportunities quickly.

Alright, we’ll leave it there for now and hopefully this will give some perspective on the strategy and help set expectations for your clients.

As always, reach out to a member of the ZEGA team with any questions.