If You Own Volatility In Your Portfolio, You're Probably Doing It Wrong

The lesson many investors have taken away from the market is that if they just buy and hold long enough, eventually their investments will rise.

I do believe this is broadly true, particularly when it comes to U.S. stocks. However, it’s also true that if the time frame is long enough, any investor is bound to experience extreme bouts of volatility, whether it’s a once-a-year pullback or once-in-a-decade seismic volatility event like what we just got.

If 2020 has taught us anything, it is that the world has become more interdependent and growing increasingly more complex. An interconnected, more complex market creates more uncertainty and increases risk. It is now more important than ever to turn to a new asset class to give investors a true diversification of risk: volatility. 

Volatility Is An Asset Class

Most investors think of volatility as the risk of owning assets. Others know it as the insurance premiums investors pay to protect a portfolio. And others yet think of it as a YOLO (you only live once) trade to get rich quick or go broke. 

Being a former options and VIX market maker, I believe all of the above are valid definitions. Wearing my options maker hat, as an investor, my preferred way to utilize volatility is to reduce the risk of owning risky assets. Yes, options and volatility trading can make investments riskier, but they can also be used to make investments less risky.

Let’s discuss volatility as simply as possible. There is realized volatility (the actual movement of a stock or future over time) and there is implied volatility (the expected movement over time determined by options premiums). Realized volatility is how much the market moved, and implied volatility is a measure of the uncertainty of the future.

Realized volatility and implied volatility are critical components of owning volatility as an asset class. When an option is purchased or sold, the implied volatility will determine the price, which means the market’s best guess as to how much the market will move until the option expires. 

The profit or loss is then determined by the gap between the actual movement, and the implied movement which was traded. To put it another way, when trading options, volatility as an asset class is a bet on the gap between the implied volatility and realized volatility. This was the only method of owning volatility as an asset until the introduction of VIX futures in 2004 and VIX options in 2006. 

How VIX Futures Changed Volatility

Up until then, the VIX, a measurement of the next 30 days of expected market movement had merely been a useful tool to measure implied volatility. But the introduction of futures allowed for a pure implied volatility asset.

VIX futures have fundamentally changed volatility as an asset class. Trading a VIX future is a pure bet on future changes to implied volatility, rather than trading the gap between implied and realized volatility.  Implied volatility and equities have a very high negative correlation.  

This negative correlation has been a key reason as to why VIX futures have become so popular and why billions of dollars are flowing into the VIX as an asset class. Popular exchange-traded notes (ETNs) have since emerged allowing anyone to participate in a volatility trade. 

Now, 15 years in, the VIX has matured to a place where it can be held efficiently as an asset class. However, the VIX is still completely misunderstood and even dismissed because of poor execution by traders and investors who have not understood how to best utilize volatility as an asset class.  

The Mistakes People Make When Owning Volatility

There are key problems that investors have when buying the VIX. 

The first is that the VIX futures are very hard to understand for someone who has not been following them like a market maker. They move independently of the VIX index, and are only predicting the closing price on expiration. They are still very highly correlated with the VIX index, but that correlation changes the longer the time is until expiration.

Further VIX futures have become a victim of their own success. Their popularity has led to a crowded market which increased the negative decay associated with contango (a negative slip associated with holding futures for a long period of time).  I can write a whole paper on contango, but for the purposes of this article, all we need to know is that contango is why so many long futures traders lose money. 

Investors, who loved the idea of a fast pop in VIX futures were far to slow to catch on to the cost of owning VIX futures as a buy-and-hold investment.  In the trading pits, we used to say "VIX futures, you can't be long them, you can't be short them.” 

Secondly, we need to accept that owning volatility as an asset class via implied volatility is different than other asset classes because volatility has no long term positive expected value. 

Volatility does not earn anything nor pay any direct return such as interest or dividends.  You cannot put your VIX future in a safe, you can’t use it to make products such as computers or jewelry, it’s just a calculation on a computer.  While most asset classes over the long term will trend higher, the VIX will ultimately wind up in the same spot because the VIX is mean reverting. The higher it goes the harder it is to go higher, and the lower it goes the harder it is to go lower. This means that owning the VIX in a buy and hold strategy does not help the long term performance.

10-year chart of the VIX (white) vs. front month VIX futures (blue) and the iPath Series B S&P 500 VIX Short-Term Futures ETN VXX (red)

The Best Way To Own Volatility

The solution to owning volatility as an asset class is to make it as simple as possible.  A VIX futures position should remain constant, which means they need to be actively managed and actively traded. 

Thinking like a market maker, the VIX can be treated like a put option, the lower the stock goes for the owner of a put option, the more short stock exposure the option gets.  A market maker would close the short stock buy buying, which allows him or her to buy more stock when the market goes lower while at the same time reducing volatility as it goes higher. 

Actively trading the VIX with a long risk asset such as stocks keeps a portfolio appropriately risk hedged. Many hedgers do not know what to do when the VIX goes up. Should they sell the VIX because it might fall? If they do that, do they need to sell their stocks because they will be unhedged now?  No, the solution is to keep the right ratio on at all times. Harvest the returns of being long volatility, and put it back into your stocks. Buy stocks lower, sell volatility higher.  

Tragically it seems that most people utilizing the VIX are hoping that the market is going to zero, and the VIX to infinity. I think they are not being realistic.

The realistic view is that the market will not go to zero, instead trend higher over time.  There is an appropriate component of volatility in a portfolio, but it needs to be maintained so that we can utilize it to add alpha. Thus, holding volatility at a consistent weighting is how we can achieve the maximum benefit to volatility as an asset class.