Volatility Investing on the Rise—Get to Know the Strategies

As the markets have become more turbulent in recent years and expected returns from traditional assets look tepid at best, investors and advisors are increasingly turning their attention to volatility strategies, which has sparked significant growth in new product development. 

As of July 13, 2016, there were 165 open-end mutual funds with the word “volatility” in the name according to Morningstar, Inc., a leading provider of investment research. Of those 165 volatility funds, 115 or 70% launched in the last three and a half years. And these are only funds with word volatility in the name. 

Volatility strategies can be defined much more broadly than just how they’re named. For our purposes we consider any strategy where volatility has a significant impact on performance as a volatility strategy, and that includes all strategies that employ options. 

Options are contracts that give the holder the right to buy or sell a security at a specified price on or before a specified date. Unlike stock prices, options prices are greatly influenced by market volatility and therefore provide exposure to volatility as an asset class. Higher volatility drives up options prices as demand for options rises in turbulent environments, and higher volatility also makes options more likely to go into the money, which also affects the price.

Options usage is on the rise. Trading volume at the Chicago Board of Options Exchange (CBOE), the largest U.S. options exchange, grew from 1.1 million contracts in 1973 to 1.2 billion at the end of 2015. 

While options have traditionally been used by institutional investors and proprietary traders, they’re starting to find their way into retail investment products. In April 2016, Morningstar added a new Option Writing category to its U.S Retail Category system to allow investors to better sort and compare options-based funds. In addition, the Institute for Global Asset and Risk Management found in a 2015 study, that the number of options-based funds grew from 10 in 2000 to 119 in 2014.

Know the Lingo

The number of different volatility strategies can be intimidating—short volatility, long volatility, managed volatility, volatility arbitrage, relative volatility, buywrite, putwrite, premium/options writing, VIX trackers, inverse and leveraged VIX trackers, covered call, and tail hedge. All these strategies seek to profit from or hedge against market volatility and most use options to try to achieve their goal, but that’s where many of the similarities end. Below is a list of seven of the most common strategies:

These strategies hold a portfolio with an asset held long while a call option is sold on the same asset. The goal is to collect the option writing premium to either add extra, incremental income above the underlying long-held asset or cushion a loss.

Long volatility
Long-volatility strategies involve buying options to try to profit when volatility rises and to provide tail risk protection.

Low volatility/managed volatility
Low volatility/managed volatility strategies seek to produce traditional equity-like returns but with lower standard deviation. This can be done with derivatives like options or by simply buying low volatility equities.

These strategies hold cash or equivalent and sell put options. The goal is to collect the option writing premium to either add extra, incremental income.

Relative volatility/volatility arbitrage
Strategies that involve trading spreads between two securities with different volatility or using quantitative techniques to capture perceived mispricing are relative volatility/volatility arbitrage strategies. The goal is, primarily, to produce an uncorrelated return stream.

Short volatility
This strategy involves writing (selling) options to try to profit from the spread between implied volatility (what investors will pay for options) and realized/actual volatility. The goal is, primarily, to produce an uncorrelated return stream.

Tail risk volatility
These strategies are similar to long volatility but specifically seek to profit in extreme market events.