Epic Failures — Lessons from Volatility Funds blow-ups

LTCM- Too Big To fail

credit: brilliant.org
  1. Assets’ prices tend to converge toward their “fair value”. Divergence from fair value cannot last in efficient market. Inherently they assumed human behavior is rational.
  2. Diversification across different markets (and regions) reduces the risk of the portfolio. Historical correlations don’t tend to break down.
  3. Historical volatility is a good predictor for future volatility (ironically, the main problem of the Black-Scholes model)
  4. LTCM was leveraged 1:27, meaning that on its $4.5bn of capital they had obligations of $125bn.

Citadel (2008) — Post Lehman equity derivatives losses

Capstone Asia Fund — Taken down by a tsunami

source: Bloomberg

LJM Preservation and Growth fund- Blame it on the VIX

Source: Bloomberg. LJM P&G share price

OptionSellers.com

Data source : Bloomberg

March 2020 — A handful of blow-ups

source: Malachite Capital Management website
  1. Understanding the risk-reward profile of your instrument — There is a huge difference between trading ATM options, deep OTM options, VIX futures, or VIX options. Each instrument has significantly different risk profile (including vol-convexity/skew), failure to understand the 2nd order Greeks is a crucial error, which, in a significant downturn, generate huge losses.
  2. Portfolio diversification — When constructing any portfolio a sufficient diversification is essential to reduce specific risk. That is true also when constructing a volatility portfolio. Obviously in a severe downturn correlation tends to go to 1, but in cases like OptionSellers.com and Amaranth even a modest diversification of the portfolio would have reduced the likelihood of blow-up.
  3. Run a very conservative risk management — As volatility strategies tend to be rather explosive in scenarios of risk-off, one should assume a very negative spot-vol correlation (i.e. volatility skew) when running scenario/stress analysis on the portfolio level. We should never assume realized volatility to persist (as LTCM did). The portfolio should be analyzed under different volatility regimes.
  4. Understand leverage — Derivatives are leveraged products, so using additional leverage should be done carefully. As we pay little to no attention to our leverage when markets are calm and going our way, a downturn can turn our portfolio to a timebomb waiting to go off.. Position sizing is crucial in avoiding margin calls and forced liquidation.
  5. Find a cheap hedge to protect outsized moves — The purpose of a cheap portfolio hedge is not to gain long tail exposure, but rather reduce the risk of catastrophic failure of the volatility strategy. A good hedge should be one that is rolled systematically with minimum P&L bleeding. When looking for such a hedge one should not look at the correlation, but rather conditional correlation (given a very adverse move of the underlying position).

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Harel Jacobson

Harel Jacobson

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Global Volatility Trading. Python addict. Bloomberg Junkie. Amateur Boxer and boxing coach (RSB cert.)!No investment advice!