Perspectives

Beyond Managed Vol—Using Volatility Strategies to Profit from Market Volatility

While many advisors and investors are familiar with popular managed volatility funds, the volatility category of strategies is vast and worth investigation. Volatility strategies have the potential to provide incremental return, risk mitigation, or return stream diversification depending on the strategy. 

Below we sort seven common volatility strategies by their primary portfolio function: 

Uncorrelated Return
Short volatility and relative volatility/arbitrage strategies derive profits from exposure to market volatility. Volatility represents the variability of an asset’s movement; it’s not used to determine an asset’s price. So, short volatility and relative volatility/arbitrage strategies can produce return streams that are uncorrelated to the market.

Incremental Income
Buy-write and put-write strategies, or covered-call strategies, hold an underlying security or cash and sell call and put options. Since these strategies hold the underlying security or cash, there’s less diversification benefit than in a short volatility strategy, for example, but the goal of a covered-call strategy is to achieve incremental income from collecting the premium on options written on the underlying portfolio securities. 

Hedge
The third category is risk mitigation/hedging strategies, which includes long volatility, tail hedge risk, and managed/low volatility. While managed volatility strategies try to achieve the performance of a traditional equity strategy but with lower standard deviation, long volatility and tail risk strategies attempt to profit from rising volatility and extreme market events.

What to Think About Before Investing

When considering a volatility strategy, investors and advisors should first determine what primary function they want the investment to play in their portfolio—diversification, incremental income, or hedging. They should also understand the best and worst environments for the strategies and how they’re being executed. The chart below provides a summary. 

 

Primary Function

Primary Exposure

Holdings

Outperforms when:

Relative Vol/Arbitrage

Return Diversification

Volatility Markets

Derivatives only or combined with equities

Market neutral. Profits when manager correctly predicts dislocation or mispricing in the volatility market

Short Vol

Return diversification

Volatility Markets

Derivatives only or combined with equities

Markets are choppy, declining, or steady

Long Vol

Risk mitigation/hedging

Volatility

Derivatives only or combined with equities

Extreme market events occur

Buy-write

Incremental income

Equity markets

Derivatives and equities

Markets are choppy, declining, or steady

Put-write

Incremental income

Equity markets

Derivatives and equities or cash

Markets are choppy, rising, or steady

Tail Risk Vol

Risk mitigation/hedging

Volatility

Derivatives only or combined with equities

Extreme market events occur

Low/Managed Volatility

Risk mitigation/hedging

Equity markets

Derivatives and/or equities

Equity markets are rising

As the stock market teeters at record highs and bond yields sink to historic lows, we expect more investors and advisors to turn their attention to alternative investments, including volatility strategies, to enhance portfolio return.