Incorporating volatility-based investment strategies within equity and bond portfolios is an effective approach to increase portfolio returns while simultaneously managing portfolio volatility. There are clear alpha-generating opportunities in volatility that add diversification to investors’ portfolios across equity, fixed income and alternative asset classes and take advantage of natural inefficiencies in markets.
Why volatility-based strategies can act as an effective diversifier?
- The volatility of returns of an asset can behave independently of the asset itself, and opportunities exist to diversify a portfolio by investing across both an asset and its associated volatility.
- Volatility strategies themselves are generally uncorrelated to underlying asset for two primary reasons.
- First, the volatility of future price movements is uncorrelated to the current price of the underlying asset.
- Secondly, the expected volatility of the asset does not factor into the current price of the underlying asset.
- Volatility strategies can also provide effective diversification due to the difference in asset cash flows relative to price movements of the underlying assets.
Key differences between volatility investing and traditional equity and bond investing:
- This first key difference is that volatility investing is about more than simply reaching a final destination for price or income, and profit or loss cannot be determined simply by looking at a traditional chart.
- In addition, the universe of volatility investors or market participants is different, which generally falls into three categories:
- Hedgers buy options against their portfolios, which tends to push implied volatility, or the level of future volatility predicted by the option price, above realized volatility, or the actual volatility of the asset over time.
- Yield enhancers suppress volatility by selling options to earn carry and add to returns.
- Relative value traders seek to identify opportunities created by the mismatch of opposing flows of the other two; the mismatch between supply and demand occurs across the spectrums of time, expiry and underlying product.
- Volatility option trading is path dependent.
Common trading strategies of volatility investing
- Delta hedging. Capture the difference between implied and realized volatility – to sell options and rebalance a portfolio position to limit risk
- Strategies employed by tail risk funds which are the opposite of delta hedging. Tail risk funds buy options in the hope of profiting from tail events. These positions are to hedge portfolios and usually benefit in a risk-off environment.
- It has been proved that some of the best volatility-based opportunities are a combination of long and short volatility strategies that look to capture supply and demand imbalances. The demand imbalances are caused by forced buyers resulting from regulation and hedgers; the supply imbalances typically emanate from investors looking for additional yield on their investments via strategies such as selling covered calls on single stocks or investing in callable bonds. These imbalances can lead to attractive trading opportunities.
- Another tactical opportunity is beta replacement using options to replicate a long position. For instance, there is demand for out-of-the-money (“OTM”) put options on equity indexes, which causes puts to trade at a much higher premium than equally OTM calls.
Every tactic has drawbacks that make an investment unsustainable for the long term. Dynamic portfolio management based on pre-emptive as well as reactive hedging reduces a significant portion of the impact of a duress event on the spread and mitigates some of the drawdowns during period of a rapid rise of volatility in the markets. A successful short volatility portfolio must also incorporate dynamic rebalancing and sound management principles as well.
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