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Duration Matters

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Managing Expectations for the DRS during Drawdowns

This is the final of three blog posts in which we explore the vari­ables that will impact the DRS’s per­for­mance dur­ing a down­turn.  Those three pri­ma­ry vari­ables are:

  1. The speed of the sell-off,
  2. The mag­ni­tude of the sell-off, and
  3. The dura­tion of the sell-off

With speed and mag­ni­tude already dis­cussed, the final top­ic on our list is dura­tion.

 

Duration of the Sell-Off

The dura­tion of a mar­ket down­turn typ­i­cal­ly impacts the prof­itabil­i­ty of the har­vest­ing of option pre­mi­um trades. Usu­al­ly dur­ing mar­ket sell-offs there is a height­ened lev­el of mar­ket volatil­i­ty. Dur­ing these envi­ron­ments, option pre­mi­um is often described as “rich.” In oth­er words, it’s a seller’s mar­ket and the price of options is high for those will­ing to write them. The DRS prefers that the dura­tion of the sell-off last longer, so that we can exe­cute mul­ti­ple trades at these rich lev­els of pre­mi­um. Con­verse­ly, if a sell-off is short-lived and quick­ly for­got­ten, we aren’t able to col­lect as much pre­mi­um as we would have liked for as long as we would have liked.

It is cer­tain­ly pos­si­ble to prof­itably har­vest option pre­mi­um dur­ing peri­ods of low volatil­i­ty because the pri­ma­ry dri­ver of an income trade is the gap between implied and real­ized volatil­i­ty. How­ev­er, the “sweet spot” for the DRS is mod­er­ate lev­els of volatil­i­ty, with VIX lev­els in the mid-teens to low-20s range.

Favorable vs Unfavorable - Swan Insights

Source: Swan Glob­al Invest­ments; hypo­thet­i­cal rep­re­sen­ta­tion

 

Unfavorable Scenario: June 2016, Brexit.

On June 23rd, 2016, vot­ers in the Unit­ed King­dom shocked the polit­i­cal estab­lish­ment by vot­ing in favor of “Brexit”—the depar­ture of Great Britain from the Euro­pean Union. Mar­kets respond­ed neg­a­tive­ly at first, but then quick­ly ral­lied. Although the sell-off was worse in Euro­pean mar­kets, the S&P 500 was down 5.34% over the two trad­ing days of June 24th and 27th. The VIX spiked from 17.25 on June 23rd to 25.76 the fol­low­ing day.

How­ev­er, mar­kets quick­ly brushed off its con­cerns about Brex­it. Mar­kets trend­ed back upwards and by July 8th had recov­ered all of the loss­es sus­tained fol­low­ing the Brex­it vote. By July 8th the VIX was down to 13.20, low­er than where it was before Brex­it.

Dur­ing this short sell-off the DRS did well due to the hedge posi­tion, los­ing less than half of the mar­ket over June 24th-27th. How­ev­er, we would have pre­ferred that the VIX stay at ele­vat­ed lev­els in the high-teens or low-20s for the oppor­tu­ni­ty to exe­cute more trades and col­lect more pre­mi­um. Instead, it dropped back to the depressed lev­els in the low-teens where the VIX spent most of 2016 and 2017.

S&P 500 VIX Brexit - Swan Insights - Swan Global Investments

Source: Morn­ingstar Direct, Bloomberg

 

Favor­able Sce­nario: 2007-08, Bear Stearns to Lehman Broth­ers.

Dur­ing the first half of 2007, mar­kets were up a healthy amount. By mid-July the S&P 500 was up over 10% and the VIX spent most of the year in the 12–14 range. How­ev­er, on July 16, 2007, Bear Stearns dis­closed that two of their hedge funds that focused on sub­prime mort­gages were all but wiped out.

In the year fol­low­ing Bear Stearns’ rev­e­la­tion, the S&P 500 trend­ed ner­vous­ly down­wards, los­ing almost 18% of its val­ue. More impor­tant to the DRS was the fact that the VIX entered a new trad­ing regime, spend­ing most of its time in the high teens or 20s. As stat­ed pre­vi­ous­ly, this is the “sweet spot” for the DRS, where option pre­mi­um is both rich and sus­tained. The DRS did quite well with its har­vest­ing of option pre­mi­um dur­ing this peri­od, the lead-up to the Glob­al Finan­cial Cri­sis[1].

S&P 500 VIX Financial Crisis - Duration Matters - Swan Insights

Source: Morn­ingstar Direct, Bloomberg

 

Conclusion

In a relat­ed note, the start of 2018 bears a strik­ing resem­blance to the start of 2007. VIX was at sim­i­lar­ly low lev­els to start the year. How­ev­er, 2018 has seen numer­ous con­cerns rat­tle the markets—the end of the easy mon­ey peri­od, ris­ing infla­tion, a poten­tial trade war, etc. Will we see the mar­kets shift from a low volatil­i­ty regime to a mid-volatil­i­ty regime, which the DRS prefers? Time will tell.

This recent series of blog posts pro­vid­ed an exec­u­tive sum­ma­ry ver­sion of the three pri­ma­ry dri­vers of DRS per­for­mance dur­ing down­turns.  For a more in-depth explo­ration, please refer to the white paper “Man­ag­ing Expec­ta­tions: Draw­down Sce­nar­ios and Swan DRS Per­for­mance Analy­sis.”  In addi­tion to these three pri­ma­ry fac­tors, the paper dis­cuss­es var­i­ous spe­cial sit­u­a­tions like V-shaped recov­er­ies, extend­ed declines from height­ened volatil­i­ty, whip­saws, and the dif­fer­ences in volatil­i­ty regimes.

 

About the Author

Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Client Portfolio Manager - Swan Global InvestmentsMarc Odo, CFA®, CAIA®, CIPM®, CFP®, Client Port­fo­lio Man­ag­er, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly, Marc was the Direc­tor of Research at Zephyr Asso­ciates for 11 years.

 

 

Important Notes and Disclosures

[1] Note to Pre-Finan­cial Cri­sis: Dur­ing the first half of 2008, the DRS also ben­e­fit­ted from the increase in the volatil­i­ty pre­mi­um of its hedge and the fact that the hedges spent most of 2008 in-the-mon­ey.

Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non-qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®).

All Swan prod­ucts uti­lize the Defined Risk Strat­e­gy (“DRS”), but may vary by asset class, reg­u­la­to­ry offer­ing type, etc. Accord­ing­ly, all Swan DRS prod­uct offer­ings will have dif­fer­ent per­for­mance results due to offer­ing dif­fer­ences and com­par­ing results among the Swan prod­ucts and com­pos­ites may be of lim­it­ed use. All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. All invest­ment strate­gies have the poten­tial for prof­it or loss. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970–382-8901 or www.swanglobalinvestments.com366-SGI-092018

By |2018-10-02T10:42:31+00:00September 20th, 2018|Blog|Comments Off on Duration Matters