Imagine the world as a snow globe-style paperweight. Donald Trump seems to perceive it as such, fond of turning it upside down with a shake. In a world filled with random events, his rapid-fire pronouncements can cause price flutters — volatility — across all asset markets. Certainly, his latest pronouncements on trade tariffs with Canada, Mexico and China have roiled markets.
Volatility can signal investor fear but also offer an opportunity to clear minded buyers. Among professional portfolio managers, views vary on what action to take to protect their clients’ funds. Some will have a proactive hedging policy, others will prefer to remain fully invested lest they mistime any asset sales.
What about the average investor? Protecting one’s liquid holdings can involve something as simple as holding more cash, or a more complicated hedging strategy involving derivatives such as options and futures. Then again, one could embrace pure risk and look for ways to profit from any bursts of market volatility.
What is clear is that volatility has risen recently. Blame the Bank of Japan for repeatedly raising interest rates early last year for the first time since 2007, or concern about persistent US inflationary pressures, or even the rising probability of a Trump 2.0 presidency, unthinkable a few years earlier. Markets began to price in the risk of unstable markets from the November US election and beyond.
Volatility is typically measured as a percentage probability, the potential for a swing in prices around an average over a given time period. How much does the market price of an asset move around daily or even hourly? Big swings and it catches the attention of financial journalists. Really huge changes get reported on the broader media of television and radio, and everyone notices.
Think back to February 2020 when the world recognised that the Covid virus could mean something bad for world economies. The S&P 500 on February 19 was up almost 5 per cent year to date. Ten days later that gain had evaporated and the index had plummeted around 13 per cent.
However, anticipating volatility and making money from an explosion of fear are two very different things. Some investors will regularly pay for protection on their holdings if they perceive a rocky year or two ahead. Others may wish to embrace volatility and seek a means of profiting from it. Volatility, like butterflies, can be easy to spot and hard to capture.
To determine which you are, wealth managers often give their clients a series of personality quizzes to assess their risk tolerances. These questions boil down to the “sleep well versus eat well” paradigm. If your portfolio falls 20 per cent in a week will you toss and turn at night, or simply wait for better days when profits may fatten your wallet?
Buying insurance on one’s holdings can be expensive. One can pay premiums for months or years and never make much of a return. There are many strategies. One of these is a systematic effort to buy derivatives, such as put options on stocks, which rise in value when the share prices decline.
There is some leverage employed here so paying for a little option premium (the price) can represent a lot of notional value. As such, options offer an efficient way to cover potential losses in one’s share portfolio. But these are also very volatile instruments.
The most common types for this purpose are put options which give one the right to sell to a dealer a certain number of shares at a specific (strike) price, by a certain date. Puts work for those expecting underlying security prices to fall. Call options offer the opposite, the right to buy shares at a given price within a timeframe. In the UK, options on the Vix index — a measure of volatility — can be traded via Charles Schwab (UK).
To say that option prices can vary greatly is a huge understatement. The combination of factors in the option price — including the price variation for the underlying cash shares (historical volatility), the time remaining to expiry and how near or far from the exercise (strike) price — can create a very short half-life for these instruments.
A trend in US markets towards trading options which expire daily, instead of monthly, have created instruments which are the equivalent of mayflies. Their premiums can disappear very quickly. Not everyone wants to sit in front of their computer screen, in a trance, waiting for an opportunity to snatch a profit. This means traders, professional and retail, must take profits on volatility options as quickly as they appear.
“What makes it hard is you have this systematic selling pressure on volatility,” says Bernie Ahkong, chief investment officer for Multi-Strategy Alpha products at UBS O’Connor. “You have to be quick to take gains.”
For those willing to pay for volatility protection, there are ways to do so relatively cheaply. One typical example is the put spread, a version of which would involve buying a put on an index, or even an individual stock, then partly covering that cost by selling a put further away from the strike (out of the money).
To be clear, this relatively “simple” strategy comes with its own risks. That short put will limit the gains in a market collapse as the put price could jump substantially leaving the investor out of pocket. Most experts would also shy from shorting any option on its own, given the potential for losses.
Advisers to more conservative investors may offer other means of protecting a portfolio from bouts of volatility. At State Street Global Advisers, Altaf Kassam, the Emea head of investment strategy and research, suggests more conventional ideas such as buying gold. This non-yielding, shiny store of value, has become in recent years an anti-dollar trade by the central banks of Russia, Turkey and China.
“To go long volatility you generally have to pay a premium [such as with options]”, points out Kassam. “You should be happy to lose money, in a way. But gold too has offered a good way to diversify.”
Rupert Howard, head of UK discretionary portfolio solutions at Pictet Wealth Management, agrees on both points. Paying for protection via put spreads, for example, is a necessary cost at times. But he does recommend safe haven holdings — such as gold and Swiss francs — for portfolios. Also, there is the obvious choice of cash given healthy short-term interest rates of over 4 per cent in currencies such as the US dollar and sterling.
“Bouts of volatility offer opportunities and you need the cash to take advantage,” according to Howard.
What if you want to embrace volatility? After all, sometimes the best defence means launching a strong offence. In a world of upside down snow globes, some investors will prefer to bet directly on volatility. Weirdly, simply raising one’s cash position can be risky.
“Quite often we have to weigh up the pros and cons of just going to cash, as a hedge,” notes Abhinandan Deb, who oversees global cross-asset quantitative strategies for Bank of America. “There are risks to that, the opportunity costs . . . getting the timing wrong. Going to cash is tantamount to taking a directional view.”
Instead, one could control the risk of volatility by treating it as part of the portfolio. It’s not always been straightforward, though. “One of the big challenges is just how short lived the volatility spikes have been,” says Deb. A buy-the-dip phenomenon has continued to persist, despite the fact that interest rates are no longer at zero. The view from bullish investors is that central banks can, when a crisis arises, cut rates and boost asset prices. “There is the perception of a central bank put,” according to Deb.
In the Trump 2.0 era, just before and after his election, a certain jumpiness among traders has reappeared. In recent months the volatility index (Vix), a measure of the implied volatility indicated by the price of S&P 500 index options, has shown flickers of life. If we track the volatility of the Vix itself, known as the VVIX, this reversed a multiyear decline late last summer.
Buying the Vix index via an exchange traded fund — a portfolio of Vix futures contracts — was once a popular idea with retail US investors. ETFs allow share transactions of funds which hold baskets of securities. Unfortunately, the fleeting nature of volatility — plus rising underlying costs — has meant that while the Vix might spike, the price of Vix ETFs might still fall over time. These ETFs have fallen out of favour in this decade partly for this reason. Most experts steer clients away from these products today.
The options market based on futures contracts for the Vix has taken over, and perversely become a means to hedge portfolios in the US. “Buying Vix calls is preferred today rather than S&P puts,” according to Max Grinacoff, head of US equity derivatives research at UBS. Traders and investors prefer to anticipate the potential for market mishaps using volatility.
In Europe, Germany has its own volatility index, the Vdax, which as the name implies tracks implied volatility on the Dax. But more popular with traders is the VSTOXX, which tracks implied volatility for the constituents in the broader Euro Stoxx 50 index.
The US remains the leader in volatility derivatives. “Where we have seen a ton of activity is Vix options; those are incredibly popular,” agrees Mandy Xu, head of derivatives market intelligence at Cboe Global Markets. In fact, other options and volatility-related products have appeared in the past couple of years.
As an example, Xu notes the increasing popularity of Defined Outcome ETFs. ETFs using this strategy offer a targeted gain, though the upside is capped for the underlying stock or index. The holder has less to worry about if equity prices do collapse as there is usually a specified floor.
For those who expect volatility spikes to peter out, this can be a way to protect one’s portfolio and capture a steady upward trend in the stock market. Assets under management for these strategies grew by 53 per cent last year to $60bn.
Other products are coming. Given the debate about the concentration of gains in the US equity market, due to the recent strong performances of leading US technology companies, a new index called DSPX has been developed by S&P and the CBOE. This tracks dispersion, the differences of returns among the S&P 500 constituents.
More dispersion suggests more opportunity for stock pickers. It also offers a hint at more volatility to come, but it’s important to understand that dispersion and volatility do not always move in lockstep. Futures contracts will follow late this year to track the DSPX. Sometime next year the DSPX could produce more ways for investors to anticipate volatility swings.
But there’s another way to view volatility: as non-correlated holdings. An old Wall Street adage points out the only thing that rises in a bear market is volatility. If so, the more sophisticated private investor might consider an addition of volatility-related instruments as an idea for one’s portfolio.
Measures of volatility such as the Vix and the VSTOXX are still near decade lows, in contrast with most asset prices over that period. As such, wealthier investors could add an element of risk diversification to their portfolios with the right kind of non-correlated volatility investment.
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