Market Commentary by Aroya Capital

Making predictions is difficult, especially about the future – Niels Bohr

The explosion in trading of equity volatility derivatives since the 2008 financial crisis has spawned an extraordinarily wide variety of approaches, postures, objectives and strategies pertaining to equity volatility. These varied objectives include risk mitigation, directional trading, market timing, volatility risk premium capture and relative value trading. These strategies might include approaches that could be described as systematic, discretionary, quantitative or opportunistic.

However, a key component that is not often discussed – does the success of a particular strategic approach require the ability to successfully predict the uncertain future? At Aroya Investment Partners we are agnostic regarding the future path of equity volatility. We focus on a relative value approach in which we seek to capitalise on persistent anomalies within the equity volatility space which does not require us to accurately predict the future path of equity volatility. Rather our strategic objective is to consistently harvest a variety of risk premium evident within the market for equity volatility derivatives while at the same time bounding our exposure to tail risk events.

We acknowledge that there are a wide variety of approaches to trading equity volatility. The following is an attempt to provide a few brief higher level observations and then describe where we fit within this broad landscape.

Equity volatility exhibits a very negative correlation to broad based equity price index movements – in the short run. There is a stochastic component to equity volatility, meaning that there is a component to equity volatility that is not predictable. Equity volatility is a mean reverting function; regardless of how sudden and dramatic a spike in equity volatility is in response to an economic, political or financial crisis equity volatility will eventually return to the more moderate levels of equity volatility that existed prior to the onset of any particular crisis. Material mean reversion typically occurs rather quickly, typically days or weeks.

There is a broad body of research and evidence from both the academic as well investment communities that supports the thesis that there are persistent anomalies evident in the market for equity volatility derivatives. In markets that are generally efficient, how can we explain persistent anomalies in equity volatility derivative markets that are liquid, deep, actively traded and widely focused upon?

One possible explanation is simply a demand/supply dynamic in which demand for long equity volatility exposure from investors seeking risk mitigation as well as directional investors seeking to establish a view regarding rising equity volatility levels creates enormous latent demand for long equity volatility exposure. At the same time, in a post-Lehman environment in which the major banks have materially reduced market making/risk taking exposures – it is not clear where the natural source of equity volatility resides.

Another way persistent anomalies in the market for equity volatility derivatives can be understood is in the context of Behavioural Economics (Prospect Theory/Loss Aversion/Endowment Effect). A 10% loss of net worth (for example) is typically two to three times as ‘painful’ as the positive utility associated with a 10% gain of net worth. This abhorrence of risk causes a skewing in the marketplace – in which the market is willing to ‘pay up’ for downside protection far in excess of an upside gain making opportunity of similar magnitude.

While predicting the future path of equity volatility is notoriously difficult – a systematically short equity volatility exposure will most likely produce a quite positive expected value return over the course of market cycles. However, a systematically short equity volatility exposure will expose an investor to bouts of extreme volatility and drawdowns that is often beyond the tolerance for risk of many investors.

For example, the most popular ‘short equity volatility’ exchange traded note is XIV – VelocityShares Daily Inverse Short-Term ETN. This ETN has been compounding at an annualised rate of 35.3% since November 2010 inception. However the annualised volatility of this ETN is 64.1% with a drawdown as large as 74.4% in 2011.

In terms of a non-directional or relative value approach to harvesting the equity volatility risk premium, the slope of the term structure of equity volatility is typically positively sloped about 80% of the time – referred to as ‘contango’.



This positive slope over the vast majority of time indicates that the persistent mispricing of equity volatility derivatives tends to be more pronounced at longer durations. Equity volatility derivatives of shorter duration tend to be more fairly valued on a relative basis to equity volatility derivatives at the longer end of the curve.

The general approach Aroya Investment Partners seeks to harvest equity volatility risk premium tends to have short equity volatility exposures at the longer end of the term structure with offsetting long equity volatility exposures on the short end of the term structure. The objective of this approach can be thought of as capturing the slope of the term structure – which is too steep, the vast majority of the time.

Tactically we generally use VIX options to establish short volatility exposures on the longer end of the term structure.

We could use VIX futures as opposed to VIX options, however, implementing short equity volatility exposures with VIX options affords a secondary source of return – the spread between the implied volatility of options and the realised volatility of the underlying VIX index over time (sometimes referred to as ‘Variance Risk Premium’).

The overarching objective of this relative value approach to harvesting the equity volatility risk premium reduces risk to tolerable levels while bounding our exposure to tail risk events.

We embrace a scenario based approach to risk management in which we constantly stress the key drivers of portfolio valuation to a wide range of scenarios – from the moderate to the truly extreme. The other key element to a thoughtful approach to risk management is encompassed in our position sizing methodology – which is rooted in a concept referred to the Kelly Criterion, in which seek to optimise the long term compound growth rate of our portfolio.

We devote an enormous amount of thought, time and effort to contending with low likelihood extreme events such as flash crashes, Black Swans and tail risk events. We avoid an approach that would require us to predict the ‘worst possible outcome’ and then hedge to that outcome. Rather we maintain long equity volatility exposures on the front end of the curve that will display accelerating long convexity in extreme market scenarios as our short convexity starts to decelerate as adverse market moves become truly extreme.

Our long equity volatility exposures can be thought of as a hedge designed to provide risk mitigation in the face of adverse and extreme market scenarios. The objective of a hedge might often be the desire to dampen interim periodic portfolio return variance – a perfectly reasonable goal. In our case, the primary objective of our long equity volatility positions is to minimise the variance of our capital requirements, thus ensuring a conservative balance sheet regardless of the severity of a market event or volatility shock.

This prioritisation of a conservative balance sheet regardless of scenario sets up the portfolio to recapture temporary unrealised mark to market drawdowns in response to a volatility shock – as the process of equity volatility mean reversion runs its course.

We will know when the market for equity volatility derivatives has become efficient and excess returns have been arbitraged away if the term structure of equity volatility remains table top flat for extended periods of time in a market environment not characterised by any particular dislocation. That will be a key indication that investors are no longer persistently overpaying for long equity volatility exposure.

Our expectations are that the existing anomalies in the market for equity vol derivatives will persist for the foreseeable future.

David Liebowitz has been an investment professional for over 33 years. Prior to founding Aroya Capital LP, David served Bear Stearns in a number of capacities from 1983 to 2005. The common thread of his experience was his involvement in proprietary trading during his entire 22 years career at Bear – initially Risk Arbitrage and then Convertible Arbitrage for many years. Over the course of his career at Bear he managed as much as $4 billion of proprietary capital as well as $1.4 billion of client assets. In 1993 David was elected to the Board of Directors of The Bear Stearns Companies, Inc., serving as a director until 2001. For more information please visit