Risk management at Vega

During a bull market, The Vega Fund usually holds long market exposure. This presents us with downside risk if a crash were to emerge. How do we deal with such risk?

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From: Scott Shuttleworth

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Over the past few years, I’ve studied market crashes and have categorised them into two types; financial crashes and economic crashes. Below I review the difference and demonstrate how Vega deals with each accordingly.


Financial crashes 

Financial crashes are short-term in nature and usually see the market dropping by 5-20% - although more is possible. Financial crashes don't last long because the economy is strong and confidence soon returns as investors realise that companies won't be reporting 5-20% drops in profitability.

I call them financial crashes because they're really just a lack of confidence from the financial industry and are not reflective of the state of commerce more generally.

We manage the downside here via being long short-dated VIX futures/derivatives as a hedge to our core portfolio of long market exposure. As the panic occurs, the VIX spikes up putting our VIX positions in a substantial profit. Our core portfolio goes into a loss but it is supported by the profitable VIX positions. The VIX positions are then sold down.

As confidence returns, our losses in the core portfolio normalise (and turn back into profits) and the VIX falls. As it falls, we buy back the VIX positions - ready in case of another crash.

Overall this means that despite our core portfolio being exposed to financial crashes, we can trade through or even make a profit.

It can take some time for Vega to trade through all the noise so such profits may not arise exactly on the day/week of the crash.


Economic crashes

Economic crashes are much more severe than financial crashes. In these cases, the stock market can fall by more than 50% and will usually require government/central bank intervention.

Economic crashes result from a deleveraging in the economy by either corporations, consumers or governments. Simply put, debt repayments must be financed by lower consumption (demand) and since demand equals supply in an economy, supply falls which means employment/industrial production/retail sales etc must also fall creating the recession.

Corporate earnings can also fall by a substantial amount which is why stock price falls can be so severe.

Long VIX positions aren't enough to weather these storms. As mentioned prior, we have algorithms which comb economic and financial data to detect recessions as they begin and re-position the portfolio to be short the market. Once detected, the portfolio will move from being long market exposure to short.

During these times, we will hold 60-100% of the fund in cash. The fund is typically long put options/debit bear put spreads and will utilise short VIX future/derivatives to control our exposure to vega (since the puts are long vega, some short VIX helps balance it). We also spread our positions over multiple securities, duration and strike prices.


Where are we now?

Last Friday (5th of October), the US unemployment rate was reported as falling to 3.7%. The risk of an economic crisis occurring whilst the unemployment rate is falling is extremely small and thus we’re still confident in our bullish medium-term view. The algorithm is actually a bit more bullish after the report than it was prior since unemployment is notably one of the drivers of the model.

Equities sold off on this news due to fears of higher interest rates. Personally, I think this is worth fading…higher interest rates do lower equity valuations however, a strong economy usually results in growing corporate earnings which drives them up.

We're still bullish, but as prior, we note that the debt bubble keeps growing.


Vega Capital is a wealth manager for high net worth individuals and financial institutions. Call us now on 1800 960 707 to find out more about how we can grow your wealth.

Vega Capital is a Corporate Authorised Representative (No. 001264482) of Alpha Securities Pty Ltd (ACN 124 327 064) AFS Licence No. 330757.

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