Investing in Volatility
One of the wonderful things about the capital markets is there is always an investment opportunity somewhere. I have spent more than two decades trading multiple asset classes including equities, bonds, ETFs, futures, commodities, derivatives and volatility. I have long been attracted to derivative trading because it allows an investor many ways to express one’s view on the markets. But of all the asset classes, I am most excited about volatility. Volatility trading describes trading the volatility or degree of movement of the price of an underlying instrument, such as the S&P 500, rather than the price itself.
Volatility has unique characteristics that set it apart from other asset classes including being range-bound and mean-reverting. This makes volatility generally easier to predict than stock price. Importantly, volatility also has structural elements that regularly provide a tailwind, perhaps greater than any other asset class, that increase the probability and degree of potential success. Thus, an investment in volatility may appreciate and recover losses more quickly than one in say stocks. Investing in volatility also provides a way to potentially earn a return from an asset class that is not solely reliant on interest rate policy, earnings or even price appreciation. Since the volatility of returns of an asset class can behave independently of the asset itself, opportunities exist to diversify a portfolio by investing across both an asset and its associated volatility.
Accepting downside exposure is a valuable source of long-term reward in equities and other asset classes that has historically provided strong risk-adjusted returns. Investors are likely to earn higher long-term returns for bearing downside risk, as is demonstrated by equity investors having the potential to earn a higher return than bond investors over the long-term. Alternatively, investors that hedge their downside risk remove much, if not all, of their long-term returns through this added cost.
The volatility risk premium is compensation that hedgers pay to speculators to entice them to offset the risk of volatility in their portfolios. With options, volatility risk premium is part of the premium paid to option sellers who generally profit since the implied (expected) volatility of options tend to overestimate their subsequent realized volatility (around 85% of the time with the S&P 500). Similarly, and relevant to how I like to trade volatility using volatility Exchange Traded Funds (ETFs), Chicago Board Options Exchange (CBOE) Volatility Index (“VIX”) futures tend to overestimate futures spot VIX. I have found that these liquid ETFs are the most straightforward way to trade volatility. I prefer the ETFs designed to provide exposure to short-term VIX futures contracts. When appropriate, options on these ETFs can also be utilized.
Selling volatility is similar to the successful business model of insurance companies which regularly collect overstated insurance payments (a risk premium similar to a volatility risk premium) with the expectation that periodically there will be exposure to claims. Accordingly, a long-term investment horizon is needed to increase the increase the likelihood of realizing the
opportunity trading volatility. While a simple buy and hold short-volatility approach can potentially provide out-sized (in excess of 100% per annum) investment opportunities during favorable periods, it also exposes an investor to potentially large drawdowns. Instead, a more sophisticated approach that alternates when appropriate between being short and long volatility can be a more favorable way to approach volatility investing.
By seeking to collect the volatility risk premium, an investor does not need to make market predictions. Instead, investing can be purely quantitative, seeking simply to harvest the volatility risk premium when it exists. So, during periods that the S&P 500 is bullish and sometimes when it is neutral, an investor can generally benefit from selling volatility because this has a positive expected return premium. Conversely, during bearish periods, where there is no volatility risk premium, an investor should seek to profit from an increase in volatility.
Volatility is a relatively new asset class, but because of its unique characteristics and the potentially favorable returns it can provide, it is an increasingly popular choice for investors.
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