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Tuesday, June 03, 2014

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

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