Absolute Returns for Individual Investors: Volatility, Part I

In late 2007, Goldman Sachs released a research note entitled “Volatility as an Asset Class,” where they argued that the diversified returns from strategies involving equity index volatility made it worthy of an allocation from investors. While I disagreed with their particular approach because of risk management concerns, the underlying point – that strategies involving volatility can generate returns independent of favorable equity markets – is well-presented and should be considered.

What is Volatility?

Because all the inputs into options pricing formulas are observable (e.g. strike price, current price, time to expiration, interest rates) except for volatility, it is essentially the “plug” in the formula that brings the option’s market price in line with its theoretical price. The exact definition of volatility is up to debate – some people believe it is expected standard deviation, others believe it is a fictional number showing how expensive or cheap an option is. For argument’s sake, let’s assume that volatility is simply related to demand for options on an index like the S&P 500. Options are most valuable when prices are expected to diverge widely, which is why higher variability of stock market returns coincides with more expensive options (for more, see “Why Options are More Valuable Now Than Ever Before”)

However you define volatility, you will keep coming back to the relationship between higher volatility, larger expected stock market moves, and higher options prices. What’s important is that trading volatility lets one bet on options prices without having the same “delta risk” of a regular put or call option on a stock or index. For a typical at-the-money option, delta – the change in an option’s price compared to a change in the stock or index – will represent the majority of the option’s change in price. But dealing directly with volatility (like the VIX) changes things.

Trading Volatility

Currently, a volatility index such as the VIX cannot be purchased directly in the same way a stock can. Instead, there are options on the VIX which individual investors can use to get exposure to volatility. Any number of options strategies can be replicated using volatility, including a synthetic long position by being long a call and short a put (or a synthetic short by being short a call and long a put).

As eluded to in the discussion of delta above, volatility options require a slightly different framework. The underlying reference is volatility itself – so the delta of a volatility option position equates to changes in volatility. The “volatility” for VIX options is now the volatility of… volatility. It might seem complicated, but is actually more common sense than it might come across.

Asset Class Upside

If you believe the Goldman argument that volatility is its own asset class – and I do, given the number and type of products linked to it – the logical follow-up is to see what value that asset class can offer.

The long-dated chart below shows the relationship between the S&P 500 and the VIX volatility index. Although not perfect, there is an inverse relationship that could make volatility useful as a portfolio hedge or for speculation. Examples of each will be explored more fully in the next part of this series.

Published in Main by Ernest Simmons.