Why invest in volatility?
It is crucial to have a good understanding of what volatility is and how volatility instruments behave to successfully navigate and invest in the growing volatility landscape. Alternative assets like volatility can offer investors an important source of investment diversification, help boost a portfolio's return, and offer a low correlation to traditional assets.
What is volatility?
First, let's understand what people mean when they refer to volatility.
Realized volatility is a measurement of historical volatility. This is the volatility that actually happened in the past but the calculation is time frame dependent which can be confusing. For example, realized volatility could refer to the daily returns of the last ten days, monthly returns for the last year, or even yearly returns for the last ten years. Frequently, traders quote an annualized thirty day realized volatility.
Implied volatility is the option market's expectation for volatility over a period in the future - usually stated in annualized terms. Whereas realized volatility is determined from historical price returns, implied volatility is forward looking and is calculated from option prices. This is the measure of volatility that underlies the VIX Index, as well as the measure that people look to trade.
What is the VIX?
The VIX Index is the most popular measure of implied volatility. Specifically, the volatility implied by a portfolio of 30 day S&P 500 Index options.
Often referred to as the ‘fear index’ or simply 'the VIX', the index represents the market's expectation of equity volatility. While the VIX Index itself is not tradable, index futures give hedgers and investors an imperfect proxy exposure to the Index. VIX futures represent the market’s best collective guess at the value of the VIX Index at their expiry.
Where do returns come from?
Volatility investment returns come from two separate but related sources:
Volatility Risk Premium (VRP)
Volatility Risk Premium is the premium hedgers pay over realized volatility for S&P 500 Index options. The premium stems from hedgers paying to insure their portfolios, and manifests itself in the difference between the price at which options are sold (implied volatility) and the volatility that the S&P 500 ultimately realizes (realized volatility).
Futures Risk Premium (FRP)
VIX Futures Risk Premium is the further premium hedgers pay for VIX futures over the VIX Index itself. This premium is often referred to as ‘contango’, and can be seen in the tendency for longer dated VIX futures to trade at a premium to the VIX Index.
Volatility investing is kind of like the insurance business.
Volatility investing should not be confused with volatility hedging. Just like you pay insurance premiums to protect your home against damage; market participants pay volatility premiums to protect against a market crash. Like insurance companies, short volatility investors can systematically harvest this premium. It is important to remember that insurance companies also make payouts after adverse events, and short volatility investors may experience similar drawdowns during spikes in volatility.
Conversely, long volatility investors seek to profit during spikes in volatility. However, the mean reverting nature of the VIX Index may cause long volatility investors to quickly give up any gains.
It is for this reason that volatility investing should only be viewed from a long term perspective and as a diversification to traditional portfolios. Like insurance companies, volatility investors shoulder risk in the short term to harvest returns over the long term.
As the name implies, volatility returns can be volatile during times of market turmoil, and properly managing risk is key to a successful investment. Along with intensive analytical and technical analysis, here are a few key points to keep in mind:
Maintain a Long Term Perspective
Volatility investing is not a get rich quick scheme. It is an asset class that offers an intriguing risk-return profile. Like any asset class, it should be thoughtfully placed in your asset allocation and outsourced to professionals if you are not constantly monitoring it.
On top of a diversified asset allocation, diversifying your volatility investment across volatility signals can help smooth returns and improve your risk adjusted returns.
To keep Volatility Risk Premium and Futures Risk Premium in your favor, it is imperative to remain systematic, properly scale your exposure, and be willing to go long or short volatility frequently and often.