A Threshold Rule for Active Long Volatility

Summary

The document describes a simplified way to represent an active long volatility allocation discussed in a portfolio research paper. The proposed rule monitors the equity market over a rolling three-month window and buys options in the direction of a sufficiently large market move: out-of-the-money puts after a substantial decline and out-of-the-money calls after a substantial rise. This makes the approach a directional response to recent market movement, implemented through options.

The source gives the threshold and option-selection direction, but leaves important trading rules unspecified. It does not define option expirations, position sizing, how long positions remain open, or whether to close them when the market moves back inside the threshold. The post asks for a more complete algorithm, and the supplied material does not resolve those design questions. The described rule is therefore a backtest proxy for the behavior of active long volatility managers, rather than a fully specified strategy that can be reproduced without further assumptions.

Key ideas

• The simplified strategy checks market performance over a rolling three-month window.
• A sufficiently large decline triggers purchases of out-of-the-money equity puts.
• A sufficiently large rise triggers purchases of out-of-the-money equity calls.
• The description omits expiration, sizing, holding-period, and exit rules, limiting reproducibility.

Tags

# How to implement an “Active Long Volatility” Strategy?


# How to implement an “Active Long Volatility” Strategy?












The research paper "The Allegory of the Hawk and Serpent" describes an asset allocation referred to as the "Dragon" Portfolio, which allocates 18% to "active long volatility". The backtesting methodology to implement this strategy is described as:

> We modeled the strategy as buying Equity volatility (via options) in the direction of the market after a move greater than +/- 5% in either direction over any rolling three months. The strategy, as presented, is intended to represent a profoundly simple (and less effective) replication of what Active Long Volatility managers do for their clients.

It also gives practical examples:

> In our historical simulations, we sought to replicate an Active Long Volatility strategy by buying out-of-the-money equity put options if the market is down -5% or more and purchasing out-of-the-money equity call options if the market is up +5% or more over any rolling three months.

However, the paper does not state how far forward the expiration date should be on the purchased options nor does it say if the option position is liquidated if the market mean reverts below the 5% return threshold.

What is the specific trading algorithm for an "active long volatility" strategy?

Thank you in advance for your consideration and response.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.