Is volatility an asset class? It’s a question we often debate. There’s no simple answer. Either way, though, it’s an academic point that matters less than our belief that volatility is an “opportunity class” – one with a variety of tactical and macro implications. Moreover, as financial luminaries from European Central Bank President Mario Draghi to Federal Reserve Vice Chairman Stanley Fischer have warned, volatility is likely to rise as the Federal Reserve approaches its first rate hike in almost a decade. Likewise, the opportunities created by volatility are likely to rise in the coming years.
One of the biggest differences between investing in volatility versus traditional “one delta” assets such as stocks or bonds is that volatility investing is about more than simply reaching a final destination for price or income. Profit or loss cannot be determined simply by looking at a traditional chart. If a stock climbs from $100 to $110 over a year, its return is 10%. But if volatility increases from 10% to 11% over a year, the return may or may not be 10%.
Like navigating busy freeways, volatility option trading is path dependent: Whether one makes or loses money depends on the path taken from point A to point B – as well as what happens en route. As with the freeways, bypassing traffic and finding an optimal route can make a big difference. As a real world example, driving From Mumbai to Pune can take anywhere from 45 minutes to four hours depending on the route and road conditions (such as, perhaps, unexpected construction). It’s a dynamic process, as volatility – or “traffic” – can create more volatility.
Another key difference is the universe of volatility investors. Volatility market participants generally fall into three categories: hedgers, yield enhancers and relative value (RV) traders. Hedgers buy options (as a form of “insurance”) against their portfolios, which tends to push implied volatility, or the level of future volatility predicted by the option price, above realized volatility, or the actual volatility of the asset over time. Yield enhancers suppress volatilityby selling options to earn carry and add to returns. RV traders seek to identify opportunities created by the mismatch of opposing flows of the other two. This mismatch between supply and demand occurs across the spectrums of time, expiry and underlying product.
Historically, banks acted as the “price police.” They were traditionally the biggest RV traders and thus beneficiaries of the flows and imbalances inherent in options trading. However, increased capital costs and regulation have made these once-profitable businesses less viable.
The result: Liquidity has fallen in some markets, prompting sharper price movements and more volatility. And this has provided an opportunity for new RV volatility investors to step in – especially investors who are more concerned with absolute returns, or alpha, than capital-cost-adjusted returns.
Classic volatility strategies
Some of the best volatility-related opportunities, we believe, are a combination of long and short volatility strategies that look to capture supply and demand imbalances. Causes of demand imbalances include forced buyers resulting from regulation and investors protecting portfolios (hedgers). Meanwhile, supply imbalances typically emanate from investors looking for additional yield on their investments via strategies such as selling covered calls on single stocks or investing in callable bonds (yield enhancers). These imbalances can lead to attractive trading opportunities. For example, covered call selling can cause single stock volatility to trade cheap to index volatility, allowing for equity dispersion trades which consist of selling index volatility versus buying single stock volatility that represent the index.
Another tactical opportunity is beta replacement (using options to replicate a long position), as supply and demand imbalances can create much more attractive payoff profiles than simply being long or short an asset. Structurally, there is demand for out-of-the-money (OTM) put options on equity indexes such as the S&P 500, which causes puts to trade at a much higher premium than equally OTM calls. For example, one could buy 1.55 units of 5% OTM calls on the S&P versus selling 1 unit of 5% OTM puts on the S&P 500 over a year, creating a potentially nice payoff profile for a long investor should the market rise within the option time frame.
The volatility opportunity
Now, back to the question at hand: Is volatility an asset class? We believe the answer is yes – there are clear alpha-generating opportunities in volatility that add diversification to investors’ portfolios across equity, fixed income and other asset classes and take advantage of natural inefficiencies in markets.