Alternative Alpha - Value of Volatility in the Markets

“The only constant is change.” – Heraclitus – 500 BC

Volatility simply describes to what degree the price of a market security typically changes. Volatility can be “high” or “low.” But volatility – at any level – cannot be given the simple labels of “good” or “bad.”

To financial professionals, volatility is an unemotional, mathematical metric. But to everyday folks, volatility spurs fearful panic when it’s high… and fearful suspicion when it’s low.

Human nature is to resist change. Volatility is change. And so it’s not surprising that most investors resist volatility.

To the mere-mortal investor, volatility is not an equation. In the best of times, it’s an emotions-stirring aggravator. In the worst of times, it’s the disrupter of our – and our investment portfolios’ – best intentions.

The bottom line is… Most investors fear volatility. But we believe the most successful investors learn to embrace it.

Let’s explore the history of volatility and consider how it may fit into your investment portfolio.

The Life of Volatility

In 1993, the Chicago Board of Options Exchange (CBOE) developed their Volatility Index, aka “the VIX.”

While the historical volatilities of stock prices have been tabulated by traders for decades, the CBOE’s VIX was the first popular method of quantifying the (expected) future volatility of prices.

“How volatile do investors expect S&P 500 stocks to be over the next 30 days?”

The sole purpose of the VIX is to answer that specific question. And it does so by sampling the market prices of options traded on the S&P 500.

Why?

Put option contracts on the S&P 500 have been used to hedge stock portfolios ever since they were introduced in the 1970s.

Remember, people don’t like change. And investors are particularly averse to volatility and losses.

Since put options are designed to gain value if stock prices fall, S&P 500 put options are in greatest demand when investors are strongly motivated to protect their long-equity portfolios.

How much investors are willing to pay today, for that protection in the future, is theoretically related to how volatile they expect prices to be.

When investors are concerned about high volatility, they’re generally willing to pay higher prices for put options. And that’s reflected in the CBOE’s Volatility Index (VIX).

Volatility Protection is No Free Lunch

Interestingly, researchers and money managers alike have noted that investors typically end up “overpaying” for volatility protection. According to Parametric Portfolio Associates, this over-pricing is the norm, occurring more than 85% of the time since 1990¹.

Said another way, investors more often than not over-estimate future volatility.

Between 1990 and 2015, the average implied volatility (as measured by the VIX) was 19.8%, while realized volatility averaged just 15.5%².

The difference between expected volatility and realized volatility – equal to 4.3%, based on the CBOE’s study – is widely known as the volatility risk premium.

Investors who are highly motivated to avoid volatility are those willing to pay this premium (i.e. put option buyers). And on the other side of the trade, investors willing to shoulder the risk inherent in future volatility can be paid the volatility risk premium.

Past results are not necessarily indicative of future results. Futures trading is not suitable for all investors.

And that brings us to put sellers, the so-called “insurance providers” who seek to capture the volatility risk premium, through their willingness to sell put options.

While there are several well-known strategies designed to capture upside volatility (i.e. trend-following), put sellers were arguably the first class of money managers to focus on the systematic over-pricing of expected volatility.

And they’ve done so with good success. Put-selling has proven to offer investors a number of benefits, as both a stand-alone strategy and a diversifier of traditional portfolios.

The Value of Volatility

The CBOE’s PutWrite Index generated annualized returns of 9.9% between 1986 and 2016, a bit more than the S&P 500’s 9.5%, and with lower volatility (10.2% versus 15.3% for the S&P 500)².

What’s more, put-writing has proven to limit drawdowns, historically. While the S&P 500’s maximum drawdown, between 2006 and 2015, came in at 50.9%, put-selling resulted in a milder 32.7% maximum drawdown⁴.

Past results are not necessarily indicative of future results. Futures trading is not suitable for all investors.

All told, put-selling has been a popular institutional strategy for decades, even if it’s been underappreciated by retail investors.

More recently, the rapid growth of exchange-traded “volatility products” has piqued the interest of investors on Wall Street and Main Street alike.

The CBOE reports that the average daily volume (ADV) of VIX futures contracts grew 16% in 2016, hitting a record high for the seventh consecutive year. Since their introduction in 2006, VIX futures volume has grown more than 130-fold⁵!

The innovation and demand we’re seeing in the volatility-trading space has naturally translated to the managed futures industry. Building on the groundwork laid by put sellers, a number of Commodity Trading Advisors (CTAs) are now specializing in volatility.

And the best part is, this new breed of volatility traders isn’t limited to being “long” volatility (like most trend-followers) or “short” volatility (like put sellers).

Several of the volatility-trading programs we’re familiar with seek to profit from volatility spreads and the arbitrage opportunities they present, regardless which direction the stock market is trending.

These opportunities can potentially offer investors a market-neutral exposure to volatility.

The Bottom Line is…

Volatility is a fact of life – you can either fear it or embrace it! We believe volatility, as an asset class, offers a number of unique advantages.  So if you have even a shred of curiosity about how volatility may benefit your portfolio… we should talk!

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Capital Trading Group, LLLP ("CTG") is an investment firm that believes safety and trust are the two most sought after attributes among investors and money managers alike. For over 30 years we have built our business and reputation in efforts to mitigate risk through diversification. We forge long-term relationships with both investors and money managers otherwise known as Commodity Trading Advisors (CTAs). We are a firm with an important distinction: It is our belief that building strong relationships require more than offering a well-rounded set of investment vehicles; a first-hand understanding of the instruments and the organization behind those instruments is needed as well. Futures trading is speculative and involves the potential loss of investment. Past results are not necessarily indicative of future results. Futures trading is not suitable for all investors. Nell Sloane, Capital Trading Group, LLLP is not affiliated with nor do they endorse, sponsor, or recommend any product or service advertised herein, unless otherwise specifically noted. This newsletter is published by Capital Trading Group, LLLP and Nell Sloane is the editor of this publication. The information contained herein was taken from financial information sources deemed to be reliable and accurate at the time it was published, but changes in the marketplace may cause this information to become out dated and obsolete. It should be noted that Capital Trading Group, LLLP nor Nell Sloane has verified the completeness of the information contained herein. Statements of opinion and recommendations, will be introduced as such, and generally reflect the judgment and opinions of Nell Sloane, these opinions may change at any time without written notice, and Capital Trading Group, LLLP assumes no duty or responsibility to update you regarding any changes. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Any references to products offered by Capital Trading Group, LLLP are not a solicitation for any investment. Readers are urged to contact your account representative for more information about the unique risks associated with futures trading and we encourage you to review all disclosures before making any decision to invest. This electronic newsletter does not constitute an offer of sales of any securities. Nell Sloane, Capital Trading Group, LLLP and their officers, directors, and/or employees may or may not have investments in markets or programs mentioned herein.