Saturday, February 27, 2016

Volatility as an Asset Class


The concept of volatility is nothing new and in fact options contracts, the primary method through which volatility is bought and sold, were actively used by investors as early as 1637 during the Tulip Mania.  So why, in this modern era of flash crashes and high frequency trading is volatility still a topic left on the back burner?  Is it because the topic of volatility is so mathematically complex that it does not work well with mainstream media or is it because of a persistent lack of financial education among the general investing public?  I think that the answer lies somewhere in between these two questions and I hope that this article helps some people to discover volatility as an asset class.

When you think of asset classes you normally think of things like Stock, Bonds, and Real Estate.  If you've been an investor for very long you've probably realized that diversification among asset classes is an absolute must and your portfolio is only stronger because of it.  The simplified way that I use to identify something as an asset is that it has the ability to rise in value or appreciate over time.  As an investor I want to put as much of my money into these types of things as possible.  I think inverse volatility fits perfectly into that definition because of volatility's natural tendency to depreciate over time.

Think about it, why should volatility persistently increase over time?  People continuously create, invent, and imagine new technologies that remove uncertainty in the world.  We have the resiliency and the resolve to work through difficult problems, learn from our mistakes and come out stronger on the other end.  The free market mechanism itself is designed to achieve efficient price discovery which is all about eliminating volatility and uncertainty.  Think about building a long term investment in the idea that fear and uncertainty generally subside over time.

I'll be the first to admit that taking a buy and hold or rather a sell and hold approach to volatility is not easy and can be quite dangerous if done incorrectly.  The first rule I would introduce would be that the investment should not lose more than initially invested which would rule out the use of margin.  The second rule would be that the investment should not overwhelm your entire portfolio but rather be complementary to it...always think diversification.  Finally, think about adding to this investment in small increments over time especially when every other financial news story has a doom and gloom tinge to it.

The mechanics of putting on an investment like this are normally meant for the sophisticated investor as it would require solid knowledge of options as well as a large enough portfolio to support optimally sized positions.  Say however that you are a novice and want to be involved in a small way.  Thankfully, there are several inverse volatility linked ETFs to use at your disposal.  These vehicles are a great way to be involved without having to manage your own options portolio.

Responsibly selling volatility is a great way to put time on your side and to turn the marketplace's tendency towards fear into a diversified income stream for your portfolio.  Remember, as with anything, don't over do it, be long term and stay diversified.