Volatility as an Asset Class
Volatility is often thought of as a yardstick of risk, but to experienced traders, it’s an asset unto itself, Paul Stephens, head of institutional and international marketing at Chicago Board Options Exchange, told Markets Media.
“Many people might think of volatility as a risk factor, or something that you need to think about as something that’s a negative,” he said. “The most important thing is to turn that around, and talk about how volatility itself can be thought of as a source of opportunity, and this notion of volatility as something that’s tradable You can invest in it.”
Stephens will be speaking at Markets Media’s Chicago Trading & Investing Summit on Sept. 23.
In 2014, it’s become fashionable to speak of volatility as being low, but the real issue is not whether VIX is high or low, but what strategies can be employed to take advantage of VIX at any level.
One strategy for using VIX is a buy low, sell high strategy, where if one believes VIX to be at historically low levels, one can think about strategies to go long volatility on the expectation that volatility will get back to more normal levels, and therefore profit.
Investors can also think about long volatility strategies as ways of diversifying other parts of their portfolio. For example, if somebody is overweight equities, they can lower their risk by simply selling off some of their equities, but an alternative to this is buying volatility in order to diversify and cut the risk down. “Both of these are long volatility,” said Stephens. “One of them is more of a speculation of volatility. The other is hedging on parts of your portfolio.”
A second strategy is sell low and buy back lower. “If volatility is at fairly low levels, you can sell volatility short on the expectation that the settlement price will be less in the future,” Stephens said. “You sell volatility forward at a price that’s higher than you think that volatility is going to end up.”
Investor confidence in the continuation of low volatility and ample funding at low rates has encouraged market participants to take increasingly speculative positions on volatility in derivatives markets, according to the Bank for International Settlements.
The popularity of such leverage-like investment strategies can be gauged from open interest in exchange-traded volatility derivatives, the BIS said in its quarterly report. “CFTC positioning data indicate further that speculative traders have significant overall net short positions in VIX futures, a sign of their continued willingness to sell insurance to other investors against rising volatility, despite a fairly narrow volatility risk premium,” the report said.
The VIX index is a popular index that measures the expected volatility of the S&P500 index. CBOE’s VXTYN applies the same methodology, but instead of the underlying being the S&P500, the underlying asset is ten-year Treasury futures.
“The idea is that if you have a view on the volatility of the ten year treasury bond future, you can use futures on our VXTYN index to implement a view on where you think volatility is going to go, whether you think it’s going to go up or down, and you can use it to hedge your Treasury exposures,” said Stephens.
When Stephens talks to investors, one of the common pushbacks on hedging with options or volatility is people saying they hedge their equity portfolios with long term U.S. Treasuries.
“If you look at back tests on how that may have worked for you, it’s a pretty defensible argument,” Stephens said. “The problem with that argument is you’re fighting last year’s battle. Because as interest rates can go up, your bond portfolio goes down, and your stock portfolio goes down, so your hedge doesn’t quite work for you. The VXTYN might work out very well for hedging fixed income portfolios.”
Featured image via zhu difeng/Dollar Photo Club
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