What are the risks associated with your strategy?

First, I would suggest reading the prospectus for the specific ETPs you intend to trade. What I write below isn’t meant to override those risks identified by the ETP provider.

Having said that, I view the biggest risk of the strategy to be a catastrophic move within a short time frame (October, 1987 being the quintessential example).

Because on the vast majority of days we have exposure to inverse VIX ETPs (ex. XIV and ZIV), that single day move would most likely come in the form of a spike up in volatility as a result of a crash in the equity markets.

Note that I’m not talking about normal market gyrations. I’m talking about catastrophic, historically-significant moves. The kind that your children will be able to quote from memory.

Historically, most crashes of a magnitude that would cause us serious harm have come with some forewarning. The crash tends to be preceded by a softening in the markets. We’ve designed the strategy so that, given enough forewarning, it will pare down exposure (or shift to long VIX ETPs), mitigating or even profiting from the crash.

But there’s no guarantee that the next catastrophic move won’t come without that forewarning. We trade very volatile products using a purely directional strategy without protective stops. We’ve done what we can to create a strategy that detects when the market is prone to breaking down, but the risk still exists.

Why don’t we employ stops? Because in all of the testing we’ve done (which recall, includes the 2007/08 market, one of the most destructive in the market’s history), stops have significantly reduced performance, both in the absolute and risk-adjusted sense.

The problem lies in the fact that the stronger the VIX spikes up, the more likely it is to revert back to “normal” levels. Employing stops has historically almost always taken the strategy out at precisely the wrong time. With VIX products, things definitely tend to be darkest just before the dawn.

There are other risks as well, such as specific indicators that we use becoming ineffective, or a fundamental change in how traders price risk, but these would likely play out over a longer period of time, giving us (and you) plenty of time to adjust.

The catastrophic crash risk I discuss above is I believe the much bigger concern, and reinforces the importance of relegating these instruments to an appropriate percentage of your total portfolio.

Posted in: About Our Strategy