Why do so many investors get caught short by volatility and end up suffering losses as a result? Let’s take a look at the various methods employed for trading volatility and see if they represent a rational approach. It is a popular trade and comes in a few forms, most of which invite a typical oversold posture. And finally, what results?
Start with the truest instrument for investing using volatility: options. During the old days of studying option theory with Myron Scholes while at the Chicago GSB, now named the Booth GSB, we studied the parameters and in depth aspects of option theory.
There are several parameters that determine an option’s value and performance. Commonly understood and typically focused upon are: Strike, in the money amount (Intrinsic Value), and Expiration. Easy layers to understand. The change in value of the option relative to the change of value on the underlying instrument is called the delta. A first derivative aspect for those mathematicians out there. But the next parameter is called convexity (or called gamma, a reference in some markets.) This third derivative is actually the change in the change of the option value as the underlying instrument. Hold on to that more subtle aspect because it is the essence of options. A call, option to buy will perform better as it gets longer as the underlying also rallies A put will get shorter as the underling instruments sells off, which is favorable. In fact long optionality helps as the market moves. Short options are challenging as the market moves because your position performance worsens due to convexity! Enough about defining things, let’s see what we SHOULD do with convexity.
If you are long optionality you are seeking to adjust positions as the market moves to garner the extra performance from convexity. Take bite of profit. This is a lot easier than being short volatility. So why sell volatility? Those who are long volatility face a diminishing value over time as the option decays over time. There is a trade off happening.
Long volatility positions through options are viewpoints that the shift in effective position due to convexity will pay off greater than the time decay factor. And thus, the premium in options is a statement about expected or implied volatility. Short option players think they can get the decay and watch the option they sold expire and they keep the premium. This is the pure approach.
Investors instead use options and other volatility related instruments as a form of return enhancement. Buy-write strategies, selling the VIX, buying mortgage backed securities for their yield above owning Treasuries of similar maturity, and selling options outright, all garner a little extra return but create an appetite to be short volatility that is often mispriced.
The bevy of strategies typically create a combination outcome for the option and the underlying which has good architecture and is strategic in its logic, but loses sight of the proper option price at which to work the position. Look at “buy-writes,” where a stock is purchased and a call option somewhat out of the money is sold. No one is concerned about anything but return enhancement. Is that option sale earning enough premiums relative to likely actual volatility expectations? How is that judged when convexity and implied are not part of the though process?
The result is that options are sold at levels of implied volatility that underestimate future volatility. This is also true for short volatility post ions seeking just that extra bit of return to enhance performance in a highly competitive environment. Short VIX positions come to mind. Even mortgage backed securities have an inherent short option position due to prepayments. That earns the MBS some extra spread over buying a similar maturity Treasury note. Although it looks like a winner, selling volatility works over periods of time but gets hit badly when volatility actually picks up . Evidence of the oversold nature shows up when implied volatility spikes higher than actual volatility suggests. This is a black swan event in a sense, but it takes back the profit from being sort volatility.
So, can one make money by constantly purchasing volatility? That requires more courage than the market displays, losing bits everyday for the payoff that comes inevitably.
Lastly, the oversold nature of volatility that stems from strategies other than the pure form mentioned above leads to more actual volatility itself. Markets might move relative to significant new information economic data, policy changes or geopolitical shifts, but the short volatility habits increase the dimension of these moves. Keep the pure version in mind when approaching a volatility trade.
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Tom Kutzen has more than thirty years experience in the financial markets working across many markets working with all types of participant investors and many luminaries of the financial world. Tom is now sharing his years of experience in the capital markets with individuals and organizations outside the financial services industry in order to help them develop the skills necessary to further their own financial education, financial literacy and economic success. The information in TKSmartworth will cover categories ranging from Volatility; Economic Growth, Trade & Inflation; Equities; Bonds; Currencies; Derivatives; Participants; Central Bank Policy; and more.