Long-Term Trading Strategies for Harvesting Volatility Risk Premium

Volatility (or variance) risk premium is a well-known phenomenon in financial markets. Many trading strategies have been designed to exploit it. For example, we published two trading strategies that use the VIX ETF to harvest the volatility risk premium. To be more accurate, their risk drivers are

• Volatility risk premium, i.e. implied/realized volatility differential,
• Futures risk premium, i.e. futures/spot differential.

All the trading strategies designed to harvest the volatility risk premium have more or less similar risk/return characteristics. They often lead to a steady rise in equity but suffer occasional huge losses. This is not suitable for long-term investors and/or investment funds that trade less frequently.

So can we still design volatility risk premium harvesting strategies that are more suitable for long-term investors?

Reference [1] attempted to answer this question. It examined the following volatility risk premium strategies,

• Straddles and Butterfly Spreads
• Strangles and Condor Strangles
• Delta-Hedged Calls and Delta-Hedged Puts
• Variance Swaps

The paper elaborated,

In an empirical study for the S&P 500 index options market, we analyze the performance of different strategies. We compare them to each other and to equity-based factor investing strategies. The analysis shows that variance strategies differ substantially in some aspects of risk and return, are significantly positively correlated with the market, and consistently earn premiums over the entire study period. The latter distinguishes variance strategies from other factor strategies, which have not generated premiums since the 2008 financial crisis. However, variance strategies can be hit hard by extreme stock market crashes, but also have the potential to recover quickly from these shocks. All in all, the empirical results show that variance strategies can be attractive to the long-term investor-both as an alternative and as a complement to a market investment if properly designed.

In short, the authors concluded that the volatility risk premium is different from other factors, and it’s worth implementing trading strategies to harvest it. They also pointed out that the volatility risk premium factor consistently earned premiums during the study period. We note that the latter point is the reason why retail investors are attracted to selling volatility, but the price to be paid is occasional huge losses.

Based on our experience, we believe that the strategies presented in the paper are not suitable for long-term investors. However, they can serve as building blocks to build trading strategies that have better risk/reward profiles. More work is required to achieve this objective, but the authors are in the right direction.

References

[1] J. Dorries, O. Korn, GJ. Power, How to Harvest Variance Risk Premiums for the Long-term Investor, 2021, socialsoftware.fernuni-hagen.de

Originally Published Here: Long-Term Trading Strategies for Harvesting Volatility Risk Premium