The objective of our relative value strategy is to capture the persistent mispricing (overpricing and under pricing) of equity market volatility by trading volatility index futures. Specifically, our relative value strategy exploits the mispricing between the S&P 500 VIX index and VIX futures contracts.
The VIX index is non-investable, so when the VIX futures are trading at premium to the VIX index, this implies that investors are overpricing volatility. If the premium is large enough, our relative value strategy will short VIX futures, anticipating they will decline and trade more in line with the VIX index. Conversely, when the futures are trading at a significant discount to the VIX index, the strategy will go long the VIX futures, anticipating they will rise.
The propensity for investors to misprice insurance (equity volatility) is the foundational thesis for our relative value strategy. In addition, over the last few years new product innovations have resulted in a structural change in the volatility market.
Investors misprice equity volatility for several reasons. Myopia and herding cause investors to become focused on short-term events. This leads to indiscriminate selling/hedging of risky assets in times of stress, no matter the cost. Or, it causes investors to ignore potential risks in the face of a euphoric, rising market.
The best market environment for the relative value strategy is a period of flat to rising markets where volatility decreases steadily over time. Alternatively, the model does very well on the long side in periods of extended high volatility, like the fourth quarter of 2008 or more recently, the first quarter of 2020.
The worst-case scenario for this trade is a whipsaw in which an exogenous event causes a sharp one day sell off in the markets creating a sharp spike in volatility followed by a day in which the market decides that “all is well” and volatility collapses.
Based on the history of the trade we expect to be short VIX futures 40 to 60% of the time, long VIX futures 10 to 15% of the time and in cash 30 to 40% of the time. The average short trade lasts 7 days and the average long trade
