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In this lesson, you’ll dig deeper into what volatility control funds are and why they represent another important component of systematic fund flows. These strategies are designed to go long or short depending on volatility levels, and while some funds use the VX index, others rely on implied volatility and realized volatility.
We explain how these strategies often get embedded in portfolios to hedge against extreme market fluctuations and provide diversification from traditional long equity and bond portfolios. The technique varies, but from a portfolio perspective, if you target a 10% volatility and volatility is at 10%, the model reduces positions in risky assets. If volatility is below 10%, the model goes long risk assets. The funds have a target volatility and readjust exposure daily based on realized volatility. We also cover three implementation pillars: volatility target funds focused on delivering stable volatility over time, funds using a volatility cap to deliver volatility no greater than the cap, and the variable volatility cap (VVC) where the cap level depends on the loss incurred.
You’ll learn why tracking these strategies matters—with around $350 billion allocated to this strategy based on Morningstar research, representing about 2% of mutual funds and ETF assets under management. We’ve developed a model to track these funds based on the realized volatility level of the SPX index. The model creates a trigger that leads volatility control funds to go long or short based on volatility levels. Our volatility ratio uses one month realized volatility against three month realized volatility, with two triggers: if the volatility ratio is bullish, the model goes long; if not, it’s either flat or short. We also use a 10 period simple moving average (SMA) as confirmation—when the volume ratio goes above this SMA, it triggers a long in volatility.
From a practical trading perspective, you can use this model in conjunction with our key gamma levels and CTAs models to confirm your views. For example, in a bearish market scenario, you’d expect to see GEX lost in next expirations, a drop in open interest and volumes, less liquid strikes in the bid ask spread, CTAs potentially shorting at specific bearish price levels, and the volume ratio spiking ideally above the SMA 10—indicating a spike in 1 month realized volatility compared to 3 month realized volume that triggers volatility control funds to go long volatility.
Video Chapters
00:00 – Introduction to volatility control funds and systematic flows
00:27 – How volatility control strategies work with target volatility examples
01:02 – Three pillars of volatility fund implementation methods
02:17 – Breaking down the volatility control fund model
03:21 – Using the model with gamma levels and CTAs for trade confirmation
Key Takeaways
Volatility control funds go long or short based on realized volatility levels, with approximately $350 billion allocated to these strategies
The model uses a volatility ratio comparing one month realized volatility to three month realized volatility with a 10 period SMA as confirmation
Combine this model with key gamma levels and CTAs models to confirm market views and identify liquidity flows
A spike in the volume ratio above the SMA 10 triggers volatility control funds to go long volatility
Video Transcription
[00:00:00.07] - Speaker 1 In this next section we are going to dig deeper into what volatility control funds are as they are another important part of the systematic fund flows. Let's start. We saw this slide when we introduced CTAs and systematic flows. Let's review as we uncover more on these types of funds. Volatility control funds are based on a strategy designed to go long or short depending on volatility levels.
[00:00:27.08] - Speaker 1 While some of these funds use the VX index, others can use implied volatility and realized volatility. A lot of the time these strategies can be embedded in portfolios with the objective of hedging portfolios from extreme market fluctuations. They can be a good diversification from traditional long equity and bond portfolios. The technique does vary, but from a portfolio perspective. To give you an example, if we target a 10% volatility and volatility is at 10%, the model reduces positions in risky assets.
[00:01:02.10] - Speaker 1 If we are below 10%, the model goes long risk assets. The funds have a target volatility and readjust exposure daily based on realized volatility. But there are also other methods that are used by funds and in general they follow these three pillars as described in this table. Volatility target funds are focused on delivering a stable volatility level over time. Volatility funds that use a volatility cap are expected to deliver a volatility no greater than the volatility cap and finally the variable volatility cap or vvc.
[00:01:39.26] - Speaker 1 Essentially, the implementation formula is the same for the volatility cap, except the level of the volatility cap is variable dependent on the level of loss the strategy has incurred. Why do we want to track these strategies? This strategy is worth understanding and following because throughout the years exposure to it has become bigger. We are looking at around $350 billion allocated in this strategy based on Morningstar research that is about 2% of mutual funds and ETF assets under management. MENTHEREQ has developed a model to track these funds.
[00:02:17.20] - Speaker 1 Let's break down our volatility control fund model. The model is based on the realized volatility level of the SPX index. The objective is to create a trigger that leads volatility control funds to go long or short based on that level of volatility. If we break it down on the first part of the chart, you can see simply the historical price of the spx. In the second part of the chart, we take the one and three months to realize volatility and compare it in the last part of the chart.
[00:02:49.23] - Speaker 1 That is where we create our trigger the volatility ratio is using the one month realized volatility against the three month realized volatility. There are two triggers for our volatility control funds. If the volatility ratio is bullish, the model goes long, if not it is either flat or short. We then have a 10 period simple moving average. We use this second ratio as confirmation when volume ratio goes above this SMA that triggers a long in volatility.
[00:03:21.21] - Speaker 1 How do we use the volatility control fund model? This model from a liquidity perspective can be used in conjunction with our key gamma levels and CTA's models. We we like to mix up models to confirm our views. To give you an example of how this could be useful to your strategy, let's say we see a bearish market. This is how we would expect to see our models.
[00:03:45.12] - Speaker 1 Let's start from the Greeks and gamma levels. By looking at the option matrix we would expect to lose GEX in the next expirations. A drop in open interest and volumes. Also we want to look at the bid ask spread to confirm that strikes are becoming less liquid. The net GEX chart can also be used to see how GEX is being lost for the specific strikes.
[00:04:08.28] - Speaker 1 Then we look at the cta. These models have specific price triggers. Are they inputting or removing liquidity? If we are close or reached a specific bearish price level, are CTAs shorting the market or going long? Lastly, the volatility control funds.
[00:04:27.27] - Speaker 1 In this case we want to see volume ratio spike ideally above the SMA 10. What we are really looking for is a spike in 1 month realized volatility compared to the 3 month realized volume. These situations would trigger volume control funds to go long. Volatility.
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