The Value of Volatility

Terry Flanagan

An upturn in volatility could provide savvy investors with a chance to lock in profits.

Griffin Asset Management, a New York-based long-only firm that uses covered calls as a component of its investing, is closely monitoring the VIX with the expectation that a pickup will enhance the premiums it can collect on its options-writing program.

“The reason why volatility could be very important to what we are doing here is that we are running this covered call strategy now,” said Doug Famigletti, president and chief investment officer at Griffin Asset Management.

Since the market usually falls in the short term as volatility increases, there is a greater likelihood that the options will expire worthless, enabling the covered call writer to earn a premium. Rising volatility also increases the premiums the options writer can charge. “It gives us potentially more upside in our call writing program,” Famigletti said.

Beyond covered calls, volatility can be used to advantage. “If you believe, like I do, that stocks are not going to go up that much this year, what you want to do is have a systematic plan of shifting money from outperforming groups into underperforming groups, and volatility can do that,” Famigletti said. “Where you have a market that doesn’t go very far, but you have some groups that lead in the first quarter, and then different groups that lead in the third quarter, or in the second quarter, you can shift some money around a little bit.”

Yet another use of volatility is that it can create opportunity in individual stocks. “Stocks get hit just because of volatility increases, and you buy more at good prices,” said Famigletti.

One signal that volatility could be headed upwards is the absence of net sellers of VIX. Historically, and in combination with long equity positions elsewhere, hedge funds have a strong natural bias toward net selling the VIX, according to a recent note by Societe Generale.

With the forward market for VIX still in strong contango (a condition where the expected spot VIX level is lower than the futures level), without a rise of the VIX it costs money to be long and it pays to be short. The implication of this is that VIX will go higher.

“We have already started to see early signs of it increasing so far year to date,” said Famigletti. “The S&P500 was down 3 1/2%, up 3 1/2%, and all over the place in March and early April. I think we are starting to see the early signs of it. I think returns for equity, especially U.S. equities, could be anywhere from up a little bit to down a little bit this year, but without a doubt I promise that we are going to be seeing increased volatility.”

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