### Volatility as an Asset Class

I first heard of the concept "volatility as an asset
class" in 2005. At first, it sounded
like a catchword for the sell-side to push OTC volatility products like VIX
futures and derivatives and other similar products, or variance swaps. Then came 2008. Many OTC products crashed and burned --many
supposedly protective products suffered counter-party risks, something
theoreticians might ignore. 2009-2010 we saw several long-volatility only funds
suffer damaging losses, by being net long volatility at a level that seemed
cheap historically (and dirt cheap if put in the perspective of 2008 which was
still fresh in memory). Volatility, if it is an asset, is surely something of a
frivolous temper.

Is "volatility as an asset class" a myth or a hype?
Maybe it is, but I believe it is a solid concept. Unfortunately, it is also a concept that may
invite a lot of misunderstanding. First of all, "an asset" implies
volatility is an independent "object" that can be directly
traded. In that sense, the direct
tradable products like VIX futures, VXX ETN, Variance Swaps and other OTC
exotic products are such assets, but that's only a small part of the
story.

If we go one step beyond the direct tradable products as the
definition of "asset", we open up to a much richer world of exchange
traded options that have volatility implied in all of them. For us as a volatility fund trading equity
options, no doubt volatility is an asset class, a kind of assets with nonlinearity,
convexity and strong correlation that would be most suitable for a quantitative
strategy.

Options are the only asset class that entails strong nonlinearity,
as compared with other delta only assets such as stocks, ETF, bonds and
futures, the so-called “Delta One” products. The nonlinear payoff
characteristics, or optionality, come from conditional settlement and the
statistical nature of the derivative contracts.

If one looks at the VIX historical chart, one may wonder how
to trade an asset like VIX futures: most of time the only way to profit is by
shorting the asset, while in a few instances, the spikes in VIX can threaten to
undo the entire profits from short volatility in just a matter of days. Even though it is commonly known that market
going up typically correlates with VIX going down, thus a daily beta of VIX is
a strong negative number, the long term correlation between these two assets is
much weaker if measured in years. VIX
futures may be a good crisis insurance vehicle, but would have a much more murky
result if holding for a long term. That
is the common dilemma when volatility as a directly tradable asset class.

Nevertheless, volatility is best and richest tradable asset
class, even just with simple vanilla options.
There are several aspects to this statement: 1. The complex relationship between realized
volatility and implied volatility; 2. The richness in the volatility surface; 3.
The high correlation between different volatility assets that breeds multitude
of relative value strategies.

Relativity between realized volatility and implied
volatility is the area that linearized product like VIX would miss. Though Variance Swap can catch one linear
aspect of such relativity, only directly trading options with dynamic hedging
strategy can fully realize the potential.
In theory, long term realized volatility may statistically converge with
implied volatility so that no arbitrage opportunity can exist. In reality, options are all short term
products, and the profit and loss of dynamic hedging is extremely path
dependent in the short term. To make it even
more interesting, the Gamma effect is dominant factor in the day-to-day hedging
trading. Such convexity and path
dependence would make it impossible to price an option perfectly, no matter how
sophisticate a model can be. Such
challenge presents a great trading opportunity for quantitative strategy.

The volatility surface is an area rich in academic research
but lack of conclusive theory to fully describe and predict the changes. Uncertainty in Vol Surface models, path
dependence and convexity, are not the only complexity: the different rate of
changes in first order derivatives.
Gamma, Vanna, Charm, etc. are not just fancy Greeks designed to scare
the first year associates, but part of the risk management matrix that would
determine the profits. It is no longer a
simple question of “long vol” or “short vol”.
You can have a short vol strategy without losing the convexity, or vice
versa.

The correlation of volatility among individual equity names
is generally stronger than the correlation in their prices. A relative value portfolio concentrated in
volatility assets is a popular way of profiting from such correlation. Vega can be considered as a cross-asset inventory
that can be managed in a portfolio. Portfolio optimization is no longer just an
academic tool that just focuses on historical correlation, but a practical
day-to-day operation that involves multitude of risk dimension.

As a volatility fund manager, we believe the concept of
"volatility as an asset class" is not a novel marketing concept. Such an asset class has the most versatile
characteristics in nonlinear payoff, with very large set of tradable products
in exchange traded options and equity market for the quantitative relationship
to play out.

Derek Wang, CEO, Bell Curve Capital LP - dwang at bellcurvecapital.com

Derek Wang, CEO, Bell Curve Capital LP - dwang at bellcurvecapital.com