It’s quite likely that your portfolio contains an asset that you aren’t managing to the fullest. That asset is volatility.
A Shift in Perspective: Seeing Volatility as an Asset Class
Until recently, I didn’t believe that volatility was indeed an asset class–even when I was steeped in it during my decades as an options market maker. To be sure, volatility was a key input to almost every one of our multitudinous calculations, but I didn’t consider it to be much more than an exogenous input. The assets were the equities, futures, and options that we traded, not the volatility that influenced their prices.
My views evolved as the suite of volatility-linked products expanded, and I now prefer to think of financial assets as states of matter. Tangible assets like stocks, real estate, and commodities are solids. We can touch them, and we know what they look like. Fixed-income and money-market products are liquids. Heck, short-term fixed-income and demand deposits have been called liquid assets for generations.
Volatility: The Invisible Force
Volatility is likewise a gas. Even though we can’t really see or use volatility in its purest form, it is pervasive and inescapable because the price of every asset is subject to fluctuation. Some, of course, fluctuate more than others. And if you trade options, volatility is your oxygen–it is inherent to your existence.
As with oxygen, we intuitively know if there is too much or too little volatility in the environment for our comfort–and everyone’s comfort level is different. That concept hit home recently when I was hiking in the Rockies, a sea-level dweller feeling the effects of the altitude while locals blithely zoomed up the trails. We would expect a retiree with immediate cash-flow needs to be intolerant of volatility and therefore hold liquid assets that barely fluctuate in price, while a risk-tolerant speculator would have a more aggressive mix.
Managing Volatility: Tools and Strategies
The simplest way for an investor to manage volatility is to adjust one’s portfolio. Adding leverage to one’s account is perhaps the quickest way to add volatility, if a risky one, while adding short-term fixed income is a time-tested way of reducing it. But we now have a range of tools that allow us to invest in, trade, or hedge the market’s omnipresent volatility.
Managing Volatility: An Essential Tool for Traders
As professional copywriters, we understand the importance of measuring and managing volatility in the financial markets. Options traders rely on two key metrics: historical and implied volatility. Both metrics are derived from the statistical concept of standard deviation – a measure of how much a security’s returns deviate from its average. Historical volatility reflects past performance, while implied volatility represents the market’s estimation of future volatility until an option expires.
Investors seeking to capitalize on periods of high volatility often employ strategies such as writing covered calls or puts against their positions. Conversely, those who believe the market is underestimating volatility may choose to buy options, whether covered or not.
While these tactics prove effective for individual stocks and even industry groups, traders can now expand their reach to the broader market. An ecosystem of futures and options on various volatility indexes, such as the Cboe Volatility Index (VIX), Nasdaq’s VOLQ, and MIAX’s Spikes, offer opportunities to directly hedge or speculate on volatility.
Despite a recent rebound from multiyear lows, the VIX currently stands at 13.54, well below its long-term average. Traders anticipating increased volatility stemming from the upcoming second-quarter earnings season and the Federal Reserve meeting on July 25-26 might consider a strategic move. Purchasing VIX 14.5 calls and selling 17 calls expiring on August 2 for a total of 75 cents could be an attractive option. If the VIX surpasses 17 by expiration – a level seen as recently as last week – the vertical spread would be valued at $2.50.
It is important to note that while volatility products can be used for speculative purposes, their true value lies in asset management strategies. Think of volatility as pure oxygen – highly combustible, similar to the markets themselves.
- Steve Sosnick, Chief Strategist at Interactive Brokers