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The Perfect Hedge: How to Trade Volatility

Trading volatility as an asset class — that is, speculating on the frequency of market movements — is a seriously complex undertaking, so much so that some fund managers who specialize in it struggle to explain it to even sophisticated institutional investors.

It’s the diversification of such a strategy that is likely to arouse the most interest among investors, especially those with long equity portfolios. And unlike some other “uncorrelated” asset classes, where the diversification holds until times of intense market stress — which is when so many asset classes begin to trade almost as a block — volatility retains this characteristic even in the most intense market environments: When equities are losing money, volatility is paying out, and vice versa.

As such, those investors who do go this route will find that a position of around 10 percent of the value of the average equity portfolio offers unparalleled downside protection. Technical models are available to calculate the optimal exposure of volatility to a given portfolio, depending on its characteristics in terms of geography, sector, market cap and other exposures.

Traders need a strong contrarian streak to make volatility work for them. There is absolutely no point in going long volatility when it is already high, as exposure will be too expensive to be profitable. The time to invest in volatility is when the markets are calm and volatility is low, at precisely the time the need for such exposure is least obvious.

For those who are still interested in volatility but want a “light” option that simplifies the asset class and requires less understanding of the intricacies of the market, there are various products that are appropriate. These offer some exposure to volatility without having to take on the active trading of futures that constitutes volatility trading in its purist form.

Perhaps the simplest way to get exposure to volatility is via the plethora of exchange-traded funds (ETFs) based on the VIX, its European parallel VSTOXX or Germany-specific VDAX indexes. They offer all the usual advantages of the increasingly popular ETF market: liquidity; transparency; and simplicity.

A range of certificates are also available from investment banks or brokers that offer different types of exposure to different volatility indexes. These products are also best suited for those with less experience in the subtleties of the volatility market, or for those dealing with smaller portfolios.

For those looking for something a little spicier or more tailor-made, traders can buy put options or sell call options to hedge their portfolios in a way that suits their specific views on the market or the risks in their own portfolios.

Actively trading options requires a little more scale to be an attractive option because the trading costs can comprise a higher proportion of smaller portfolios. The strategy is becoming increasingly popular with fund managers, both of hedge funds and also some mutual funds — usually as a hedge but in some instances to speculate on increased volatility — though it is still unusual to see retail investors taking this route.

“The biggest barriers to entry to volatility as an asset class are knowledge and scale,” said one London-based hedge fund manager.

The boldest investors with large portfolios may have the confidence to trade futures, which eradicates the counterparty risk associated with the structured products route — a risk that is more likely to be of concern to traders taking the view that volatility will spike. But this route requires a detailed understanding of the many factors influencing the market, including dividend risk, interest rate risk and others: backwardation or contangocan mean that even traders who are right in their call about the direction that volatility is going can end up losing money if they are wrong on their call on duration.

“Its still a real niche, and although it is getting more popular with some fund managers, its inherent complexity means it is likely to remain so for a long time to come,” said Hendrik Klein, CEO at Da Vinci Invest, a Switzerland-based macro hedge fund manager. “It is too complicated for the masses.”

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