Steady Vol - Economic Explanations

Contrary to what people say every now and again, history never ends.

Humans end with a monotonous beep out of a heart monitor.

But life goes on.

When I was an English teacher in Germany. One of my students showed up for the first day of class.

She was unemployed and the local 'work office' sent her to learn English so she could get back into work.

Her English wasn't bad, but she didn't give a shit.

First class, I asked her what she had for breakfast. Nothing. Then, just 'cigarettes and coffee'. Then nothing.

After class I let her have it.

Only a week afterwards I heard her only son died. Caught a rare disease and keeled over at 10.

I thought back to the 20-something-year-old speech I gave this grieving mother and winced.

But I was sort of right!

Life is relentless, it doesn't stop for anyone.

In spite of herself, after 3 months of daily classes I noticed that she would often lose herself in class life, and join in the with the banter.

Of course she would never heal, but every now and again she'd get caught up in life and be able to forget.

Play, Rewind

As long as the S&P 500 trundles forward and doesn't end up a zero, volatility will be mean (or median) reverting.

Each point shows returns before and after and a negatively sloped ellipse.

If you subscribe to the 'fear index' interpretation of the VIX this means we will continue fluctuating between fear and greed.

Volatility keeps thumping away.

And this is perhaps one reason why the Steady Vol strategy makes a little more money than the standard S&P 500 (1 vs 0.75 Sharpe over 10 years).

If the S&P's realised volatility for the next period is vs1 and the implied vol prediction from the Vix for period 1 is vx0. Then inversely weighting our holding in the S&P 500 (1/vx0) should mean that our effective exposure to volatility remains fairly steady if vs1 and vx0 are not too far apart.

Put another way, we indirectly sell volatility by reducing our effective exposure in the S&P when the VIX implies high volatility next period and vice versa.

Not foolproof, but because volatility is mean reverting, 'high' and 'low' have more of an actionable meaning.

Plus we receive a stream of dividends rather than time value decay usually associated with holding the Vix.

Meta Analysis

Another nice related idea is 'Inverse Variance Weighting'.

This is used for meta analyses of several studies which statisticians would like to combine into one. The studies which have less variance are given more weight. This is a way to minimise the weighted average variance across studies.

Perhaps this could also be analogous to what Steady Vol does, weighting returns where ignorance of the future (or volatility) is lower.

Stormy Weather

Finally, another reason why Steady Vol works is that when choppy waters are seen on the horizon we pull in our sails, reducing potential losses.

Conclusion

There's a bunch of things going on with this simple strategy. More investigation needed to mathematically pinpoint what exactly is going on.