Playing for a Volatility Spike

Featuring Larry McDonald

Larry McDonald, creator of The Bear Traps Report, explains why he sees higher volatility on the horizon. He discusses his analysis, and lays out two ways to make the trade, in this interview with Justine Underhill. Filmed on July 19, 2018.

Published on
23 July, 2018
Volatility, Trading
10 minutes
Asset class


  • MS

    Max S.

    26 7 2018 05:38

    0       1

    Do not watch, this is wrong and wrong, terrible! Vix spot can not be traded, its the future with significant contango so the rolldown will be v. Costly to trade. Retail should not enter such trade unless they are experts in vol products.

  • JC

    James C.

    26 7 2018 03:46

    0       0

    The question is, what are the "unknown unknowns" in the market? The trade war timeline and possible scenarios are well known and understood by the market.

  • MT

    Mike T.

    24 7 2018 08:15

    3       0

    The narrative behind why one should have protection against a Volatility Spike is sound so no argument with that, although I will say I personally don't focus on Trump & trade wars, Politics, Merkel, Brexit, Tweets, the News etc because in reality the raw Econ Data has firstly in the case of China, been slowing for over 12 months, secondly for Europe slowing since Q4 2017, and now the YoY rate of change for many econ indicators in the US suggests a compelling case can be made that the US is about to report decelerating numbers also. We'll get a good steer this Friday with US Q2 GDP. Whatever it is at a 'nominal' level the number will be look 'gun-busters' compared to the rest of the world but look under the covers and as is likely the rate of change on YoY, stress YoY basis will imply slowing/deceleration not further acceleration of the US economy. I await Friday with interest.

    Against this backdrop, having some level of protection/hedge against a Volatility Spike is entirely prudent. So how do we do that? Well there are numerous methods, but in this video the answer is go long VXX and it could well work out but there are a multitude of factors to consider, the first of which is basic in the extreme. When considering a hedge for a Volatility Spike (where Equity markets go down) for anyone considering buying VXX the first decision is how many shares are you going to buy, let's call it X, and then you need to know in advance how much protection, how much of a hedge do you have if buying X quantity of VXX provide to an Equity Portfolio? Put another way, if one buys qty X of VXX, and the S&P falls 2% for example, how much will your portfolio change? For anyone struggling at this point stop right now, you have some work to do.

    A basic capital allocation approach to sizing a VXX position may now work out as expected may not provide the desired level of hedging as going Long VXX is not an optimal instrument to protecting/hedging against a Vol spike. Buying VXX is certainly the easiest to understand and sounds very tempting. Consider if you were to have an imaginary portfolio with simply VXX as the only position it would be difficult to make money just on its own due to how VXX works. As said in the Video this ETF tracks VIX futures, and here's the issue. The folks running VXX have to constantly roll their positions in VIX futures (/VX) e.g. maybe not literally in the manner suggested herewith but the following purely to get a quick appreciation of what's at work. They start off with front month exposure with say 30 days to go, and zero days exposure in next month. Following day then adjust so its 29 days front month exposure and 1 day next month exposure , then 28 days front and 2 days back month etc. Now /VX usually trades in Contango i.e. further out months trade more expensive than near term months, so in effect the VXX folks are constantly selling something cheap, and replacing it with something more expensive and this is a DRAG on the performance/behaviour of VXX. This is a consideration that folks buying VXX must be aware of and helps support the premise that hedging an Equity Portfolio with VXX is not an optimal solution to a very real problem.

    Is there a better approach? I believe yes, but competence with running a Portfolio of Options Positions is required. My Portfolio is constructed with primarily short premium positions. Each position has different directional exposure levels (Delta in the jargon) and in turn the overall portfolio has a Beta weighted Delta against the S&P 500 number. Most of the time I do not want overall directional exposure at the Portfolio level, so my P.Beta Weighted Delta is Neutral where I'm looking to make money not by up down moves in the market but by keeping a predetermined level of the premiums collected (Theta) with my short premium positions. However when it get 'twitchy' as I am now about the market I adjust my Portfolio to have a short bias, i.e. Negative Delta. The level of negative Delta is down to personal preference. So how does this help with finding a more efficient method of hedging against a Vol spike?

    I maintain a predetermined Portfolio Delta (beta weighted to S&P) to Theta ratio of 1:2 i.e. collecting more premium than my negative directional exposure. 1:2 ratio is my current preference, but the thing is I can calculate with a level of accuracy acceptable to me if the S&P moves by negative X (Vol spike) my portfolio will move by Y. I adjustment my option positions into the close on a daily basis making sure each day ends within a range of the required 1:2 pDelta/pTheta portfolio ratio. This approach is not perfect and takes work of course, but is much more accurate at arriving at a real $$ appreciation of what will happen to a Portfolio if there's a spike in Volatility than purely buying a bunch of shares in VXX.

  • MB

    Matthias B.

    24 7 2018 06:57

    1       0

    McDonalds delivers good inputs that will drive the spot volatility. However, the drawdown on the trade recommendation is that we cannot buy the VIX Oct18 contract @ 12.50, it currently trades @ 15.60. Hence, risk-reward of the trade is dramatically lower than implied in the video

  • SS

    Steven S.

    24 7 2018 02:49

    2       0

    That was extremely good ...and not just because McDonald's views mirror my own. :-) Well-reasoned arguments with clear, actionable trade ideas. Justine: excellent interviews, as always.

  • MA

    Mauricio A.

    23 7 2018 19:55

    0       0

    At the risk of making a gross oversimplification, can anyone here please explain to me why the "ooh-so-scary!" 10% tariff threat on $500B of Chinese goods isn't dead on arrival given that the CNY has already been preemptively devalued 10% against the USD by the Chinese government? Thanks.

  • GK

    Gokhan K.

    23 7 2018 19:39

    2       0

    VIX is like a lottery. It spikes just a few times a year. If you're lucky then you're long when the unexpected happens. Otherwise you lose money when you long VIX because at the end of each contract you must lose money. That's the nature of VIX. For example, buy August contract at 14.00 today and if there is no panic in the markets until 22 August, then VIX can settle at 12 or below. This means that you can lose at least $2000 for each VIX contract. Be careful when going long VIX. Shorting VIX is much more dangerous though.

  • TS

    Tyler S.

    23 7 2018 17:54

    0       0

    a few concerns with the data but I agree.

  • ns

    niall s.

    23 7 2018 13:25

    5       0

    Justine ,

    The four month Vix future is currently the November contract and is priced at about 16.02 , the 12 and change number you quote in the summary is the spot Vix and is not trade-able , see for the Vix futures curve . The Vxx ETP that was mentioned in the presentation is based on the front two months of the curve and decays rapidly when the curve is in contango , but that is not the case when there is a Vix spike and it goes into backwardation. I agree with the premise of a high probability of a Vix spike happening by October .
    Like your presentations :)

  • SS

    Sam S.

    23 7 2018 11:43

    0       0

    Good Stuff! Thx.