The Wholesale Premium in the Volatility Trade

In the previous dispatch, I outlined a trading strategy for VIX futures that sports a risk-adjusted annualized return of 24 percent. A friend who is interested in investing suggested, quite correctly, that constructing a rolling portfolio of VIX futures would require an institutional account. Basically, you’d need a seat at the big boys’ table, ie get a dealer to make the market for you. This raised the obvious question: What is the systematic advantage of having a seat at the table? What is the wholesale premium? Ie, how much more do the big fish earn simply due to their access to the big boys’ table?

We can answer this question quite precisely. Figure 1 displays the returns on the retail version of the term spread trade. We use the same signal as before, but instead of trading a portfolio of short and long maturity VIX futures, we proxy them by VIXY and VIXM respectively.


We can compare this to the wholesale strategy that trades portfolios of VIX futures directly. See Figure 2. The retail version seems to done better than the wholesale version in 2020. But let’s get to the bottom of this.


Figure 3 displays the risk-adjusted returns for our retail and wholesale strategies together with some benchmarks. The risk-adjusted return is simply the Sharpe ratio rescaled by market volatility. It allows us to make an apples-to-apples comparison of different systematic strategies and portfolios.


Table 1 displays the summary statistics of the portfolios, along with the wholesale premium. The raw return on the market (S&P 500) has been 2bp; for unhedged (-VIXY), 16bp; hedged (VIXM-VIXY), 11bp; retail vol strategy, 22bp; and wholesale vol strategy, 28bp. Because the volatility portfolios are much more volatile, we must compare risk-adjusted returns. The mean risk-adjusted return on the market portfolio has been 4.2 percent on an annualized basis; 9.4 percent for selling vol unhedged; 10.7 percent for hedged selling; 22.1 percent for retail; and 23.9 percent for the wholesale strategy. The premium is a surprisingly low 1.8 percent per annum on a risk-adjusted basis. I was expecting a larger premium. But, hey, 2 percent is large enough — particularly in an environment where the hunt for yield is a fight to the death.

Table 1. Summary Statistics. 
Market Unhedged Hedged Retail Wholesale Wholesale premium
Mean daily return 0.0002 0.0016 0.0011 0.0022 0.0028 0.0006
Standard deviation 0.0102 0.0445 0.0287 0.0286 0.0338 0.0052
Sharpe ratio 0.2559 0.5596 0.6282 1.2374 1.3302 0.0928
Risk-adjusted annualized return 0.0421 0.0943 0.1065 0.2205 0.2389 0.0184
Skew -2.0625 -2.4015 -3.2425 2.0266 0.3921 -1.6345
Data is from Jan 2, 2014 to March 16, 2020. Source: Financial Times, author’s computations.

Interestingly, both the tactical vol trading strategies are positively skewed (the right tail is fatter than the left tail). This is highly unusual. Most risk portfolios sport negative skewness. It also makes them highly attractive.

The takeaway is that it is possible for retail investors to profit significantly from this strategy. I really want to take this to production. Please let me know if you are interested.

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