Posted by: Tom McKeon on February 10, 2016
Volatility has come to be the term used when markets are under pressure and investors are unsettled. It is really just a measure of dispersion. But most investors sure know what volatility feels like, without having to be told.
What is 'Volatility'
1. A statistical measure of the dispersion of returns for a given security or market index.
Volatility is a much used word in the investing arena. It tends to be used as a proxy for downside market movement. When markets are rising, volatility is entirely benign. When markets are under pressure, volatility is malignant, and prone to cause investor anxiety. To be sure, volatility—as it is measured—has a strong negative correlation to market direction. The exhibit below charts the annualized premium captured by the CBOE S&P 500 Buy-Write (BXM) index going back to mid-2009. It is plotted against the striking price of the new, one-month at-the-money option hedge determined by the strategy hedge roll protocol. Annualized premium is a direct function of implied volatility. The relationship between market movement and premium is quite apparent. It drifts lower with implied volatility as markets rise and investor fears wane. It moves higher as markets move lower. Just as lung cancer does not cause smoking, volatility does not cause market movement. Volatility is a measure of dispersion of returns and the level of expected volatility implied by option prices is strongly biased by and is a reaction to recent market movement.
Volatility is most readily observed and measured by the volatility embedded in the prices of options. The Chicago Board Options Exchange (CBOE) calculates and updates the values of at least 29 indexes designed to measure the expected volatility of different securities. The CBOE Volatility Index (VIX)—is defined as the measure of market expectations of near-term volatility conveyed by listed option prices. The CBOE bills the VIX as the world’s most widely followed barometer of investor sentiment and market volatility. Futures and options contracts are now available on the VIX and some of the other volatility indexes. A handful of ETFs are also now available for investors to gain exposure to volatility, either long or short.
Is Volatility an Asset Class?
These exposures raise an interesting question amongst investment professionals: Is volatility an asset class? While it is now possible for investors to express their views on future volatility—and market direction—through the above mentioned instruments, it is a stretch to consider volatility an asset class. It has no balance sheet, earnings, cash flows or dividends, makes no product or service. It is not a debt instrument with known coupon payments or a terminal value. It is not even a commodity like oil or gold with some utility to the world. It has no expected rate of return like stocks or bonds. In our view, volatility does not meet the standard of asset class. It is simply a measure of aggregate investor sentiment about near-term price movement.
That does not mean that volatility has no utility to a prudently allocated and diversified portfolio…quite the contrary.
Volatility is one of the components of option prices and pricing models (time to expiration, interest rates, strike price, underlying price and volatility), and probably the most variable. Option prices are indeed how the CBOE measures the volatility implied by market participants. But here is the interesting thing about option behavior. Options have a finite life. They expire. No matter what volatility was implied by the price of the option over its lifespan, at expiration, time has run out, the price of the option is reduced to its intrinsic value and with it, the volatility component of option prices vanishes.
While volatility may wax and wane over the lifespan of an option, the river of time runs in one direction only, and ultimately overwhelms the impact of volatility on option prices. This effect is known as (time) decay. The time premium component of option prices decays as time passes. So while volatility and time are joined at the hip, the passing of time erodes option prices. This is now something that investors can take advantage of.
Enter the Buy-Write
Full disclosure: we manage and market a suite of buy-write strategies at Clothier Springs Capital Management.
A buy-write (covered call) is the most basic hedged construct. It pairs a long exposure with a short call option. The resulting position greatly reduces overall risk, as either the long underlying or short option hedge is working in the portfolio’s favor. And no matter what, the river of time flows onward and option prices decay along with it.
For a buy-write portfolio, selling an option collects a cash flow for the seller. This cash flow is a new source of portfolio total return, enhancing returns and mitigating downside risk. The risk of being short a call option is limited or “covered” by owning the underlying asset, such as the SPY.
While time remains in an option’s lifespan, its price is very sensitive to “volatility.” As volatility is strongly negatively correlated with recent market action, volatility and option prices rise when the markets are under pressure and fall when markets have been rising. As such, an investor methodically maintaining and rolling a short option hedge benefits from market anxiety, collecting greater option premium while investor anxiety is elevated. No longer do investors simply have to endure the fluctuation (volatility) of their portfolio’s value, they can harvest the greater cash flows created by higher option prices driven by investor anxiety. Implementing this simple (buy-write) construct confers the benefits of adding a new source of return to a portfolio, reducing overall portfolio risk, adding a negatively correlated exposure (the short option) to the portfolio, and putting the power of the passing of time to work for the portfolio.
In portfolio management terms, a buy-write offers a powerful profile: sharply reduced risk (volatility and beta), superior risk-adjusted returns (alpha), robust, positive market capture asymmetry, smaller drawdowns and faster recoveries, and more.
Is volatility an asset class? We don’t think so. Is it an exposure that can be added to a portfolio? Yes and in multiple ways—future, option, ETF—and either long or short. Does an investor need to be careful with volatility? Most certainly and we believe the most prudent way to do so is with a rules-based structural approach that takes advantage of the realities of option pricing and time decay.
So while volatility is a permanent aspect of security prices, investors now have tools to embrace and take advantage of market volatility instead of merely enduring it.