EQD Research Quantitative Strategies Volatility

EQD Research: A VSTOXX Risk Premia Strategy With Built-In Risk Control

Sep 3, 2020

By Russell Rhoads,
head of research

Volatility indexes have received a lot of attention in 2020 based on the rapid rise that accompanied the equity market selloff associated with the Covid-19 pandemic. However, many professionals consistently pay attention to volatility derivatives in order to take advantage of implied volatility often being over-priced relative to subsequent realized volatility. Harvesting volatility risk premia is a strategy that is analogous to picking up change in front of a steam roller, you’ll collect a lot of small profits, but you need to make sure you don’t get run over by the steam roller in the process.

VSTOXX options offer a defined method of taking advantage of the volatility risk premia while also limiting losses during periods of excess volatility. Also, due to higher expected volatility of the underlying futures contracts, relative to other listed markets, healthy premiums may be realized when putting on a credit spread.  A very simple systematic strategy demonstrates this. Using VSTOXX index futures, and options prices from July 2017 through August 2020 we explored how a consistent bear call spread strategy performed over this time frame. There are two instances where VSTOXX ran up quickly over this 38-month time period which offered insight into how this strategy held up during periods of higher volatility.

The specific strategy follows the following rules –

  • Executed a bear call spread on the day before the current month contract settlement using the following month’s option contracts
  • The spread strike prices are determined using the spot VSTOXX index price
  • A call option with the strike price just higher than spot VSTOXX is sold
  • The bear call spread is completed with the call option with a strike price five or six points higher than the option that is sold being purchased
  • Hold the trade through cash settlement

For example, a trade using the May 2018 VSTOXX options would be executed on April 17, 2018. Spot VSTOXX was trading at 13.29 and the May contract at 14.85.  Based on the rules laid out above, the VSTOXX May 14 call is sold at 1.65 and the VSTOXX May 19 call is purchased for .50, resulting in a credit of 1.15 points.  The payoff for this trade at May expiration appears below.

The maximum payoff for this spread is equal to the credit of 1.15 taken in when the trade is initiated. If a quick upside VSTOXX price move developed in late April or early May 2018 and settlement came in at 19.00 or higher, the maximum potential loss for this trade is 3.85. May VSTOXX futures and options settlement came in at 13.40, so in this case the trade realized the maximum profit. This maximum profit was realized despite May settlement being a little higher than where VSTOXX was quoted when the trade would be initiated.

Consistently selling a bear call spread in this manner results in profits for 30 of the 38 monthly observations. The maximum premium taken in, which is also the trade that was the most successful, was 2.10 using the October 2018 contracts. There are two instances where VSTOXX ran up quickly over this 38-month time period. This price action offered insight into how this strategy held up during periods of higher volatility. The result was the February 2018 trade incurring a loss of 3.40 and in March 2020 there was a 4.25 point realized loss. Both of these time periods experienced shocks to the equity market that resulted in a large move for VSTOXX. However, these losses are fairly reasonable considering the fairly high 79% win rate and average trade profit of 0.30.

VSTOXX® Bear Call Spread Summary Statistics

The data show that it is possible to implement a strategy that is consistently short volatility, but does not take on an excessive amount of risk. For those who would like to dig through the numbers a bit more, the full history of following this strategy appears in the table below. All relevant information such as trade date, call strike prices, contract settlement, trade profit or loss and cumulative profit over the observed time period are displayed.

A risk premia harvesting strategy is usually associated with periodic drawdowns. This method of selling a VSTOXX call spread on a consistent basis shows that it is possible to profit from such a strategy without incurring unpalatable drawdowns in the process.