October 23, 2020 glacierinvest

Stock market volatility can appear to be quite complex to most of us. The concept itself at a high level actually isn’t that complicated. Once you attempt to measure volatility, price it and/or trade it is where the complexity arises. In its simplest form, volatility is a measure of the dispersion of returns of a stock, index or other security. For example, a stock that experiences greater percentage price increases and decreases has higher volatility than a stock that experiences lower percentage price increases and decreases. A stock with higher volatility is considered riskier because the potential for loss is greater. Conversely, the potential for gain is also higher.

In 2020, volatility has been a popular topic for a couple of reasons. The first and most obvious reason is the sharp drop in the stock market beginning in February, reaching its nadir in March followed by a dramatic reversal to all-time highs only a little over five months later. The second and less well-known reason is the conversation in financial/investment wonk circles about the importance of allocating a portion of your investment portfolio to a long volatility strategy to optimize your asset allocation over the long term. Given their complexity, long volatility strategies are something reserved for more “sophisticated” investors such as institutions (think pensions, endowments, etc…) and accredited investors.

What does it mean to be long volatility?

An investment is long volatility if it goes up when volatility goes up and goes down when volatility goes down. As an example, the stock market typically goes down when volatility goes up while increasing when volatility declines. This is the opposite of being long volatility. In other words, owning stocks is the equivalent of being short volatility.

VIX Chart

So how does one get long volatility exactly?

Simply put, an investor can get long volatility by purchasing options on stocks or ETFs or futures contracts on the VIX (the S&P 500 volatility index). However, this bears quite a lot more risk than stocks and requires a firm understanding of more complex investment principles such as rolling contracts over, theta, vega, delta, gamma, etc… Furthermore it’s fairly easy for investments in options and futures to lead to the entire loss of your investment. In the case of futures, you may even end up owing money above and beyond your original investment amount.

What’s an individual investor to do?

Unfortunately, there aren’t a lot of choices for individual investors to get long volatility. Buying out of the money put options as insurance is one way but can end up being quite expensive and ineffective if rolling of contracts is not managed properly. Again, this is quite a bit more complex than your typical buying and selling of stocks and mutual funds. Of the major asset classes that typical individual investors have access to, bonds and cash are the only asset class that has shown any sort of positive or zero correlation with volatility as measured by the VIX.

Last week, we wrote about how bond allocations can still serve an important purpose in investment portfolios even if rates are low. The main purpose they can serve is adding stability to your portfolio when volatility increases. The risk to bonds today is a rising rate environment. While the short-term trend in rates is pointing higher, the long-term trend is still one of declining rates. But to be prudent, you can protect against the prospect of rising rates by holding shorter maturity government securities or even cash to achieve the desired stability in your portfolio. Admittedly, it’s difficult to maintain an allocation to extremely low yielding bonds or cash when investment markets seem to be perpetually rising. However, the allocation serves two main purposes: 1) portfolio stability during periods of high volatility, which can wreak havoc on your emotions and 2) dry powder to take advantage of attractive investment opportunities after a period of high volatility.

For individual investors, shorter-term government securities or cash are probably the best way to counteract rising volatility while also providing yourself the optionality to purchase assets that meaningfully, and perhaps unjustifiably, decline in value.