Understanding Volatility: Who Wins and Loses from Higher Vol

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Volatility: An Investor’s Friend or Foe?

Volatility has become the ultimate financial market buzzword over the past year. This time last year we were in a super low vol environment, and former managers at Target were making headlines for earning millions on short-vol strategies. Then in late 2017 we entered the other end of the spectrum as cryptocurrencies rocketed higher with daily double-digit percentage moves. Seems like everyone was making money on volatility until they didn’t: in early 2018, crypto volatility bled into the equity markets, the VIX exploded, and cryptos were crushed.

Which begs the question: is volatility good or bad for investors? This question is particularly important for frontier market investors where thin markets and a higher proportion of retail investors usually result in more volatile markets than their developed counterparts. While the knee-jerk answer for most investors is that volatility is bad, the real answer is it depends on the type of investor.

What is Volatility?

As this is an investor education website, it is worth going into what volatility to ensure everyone is on the same page. There are two main types of volatility:

Realized/Historical Volatility: Realized or historical vol is how much an asset’s price has moved in the past. You can calculate it as the standard deviation of historical returns (usually daily) over a set time period (eg. you would look at the daily returns over the past month to find the 1M historical vol, etc.), and the vol is annualized. Anyone can calculate the realized vol and mutually agree with other investors on where it was, since it is based on available data.

Implied Volatility: Implied vol is where the market is pricing future volatility. The name implied comes from the fact that when calculating option prices using the standard Black-Scholes formula, every factor that goes into pricing it can be calculated using available data except for the volatility. So traders can take where options are trading in the market, and work backwards to find the implied volatility the options are being priced at.

To reiterate, realized and implied volatility are not the same thing – realized refers to the past volatility, and implied refers to the future. This is an important distinction that is usually lost in media articles about volatility. Usually, volatility in the press refers to the realized volatility, or events that have already happened, while investors are mostly concerned with the future, or what they should do now.

You should note also that the VIX, which is probably the most popular way for most retail investors to look at market volatility, should only be traded by people who understand the difference. The VIX is an index based off of realized vol (for the S&P 500). However, to actually trade the VIX you trade VIX futures, which are based on implied vol. If you’re wondering how people could be so stupid as to sell the VIX when it was at all time lows, it is because you could still sell VIX futures at about 3 vols above the VIX, earning “easy” carry.

It is also important to note that volatility does not naturally have a bias towards bull or bear markets, even if it seems that higher volatility is tied to assets selling off. Higher volatility does not necessarily lead to lower returns for investors, as early investors in crypto will attest to. Rather, it might be useful to think of the market in terms of whether people are adding risk (“Risk-on”) or taking off risk (“Risk-off”), and seeing how the volatility in your chosen market looks in that context.

Who Benefits From Higher Volatility?

There are actually many types of investors who would benefit (or claim to benefit) from higher volatility.

  • Day traders and fast-money hedge funds have a lot more opportunities to trade wide ranges in higher volatility environments, but will usually find that trading momentum based moves was a lot easier.
  • Options buyers and vol traders in general also usually welcome higher vols. All options (both puts and calls) are worth more with higher implied vols. Also, with low vols, there is an upper limit to how much more you can earn by selling more vol, which leads to the need to upsize the amount you need to sell to maintain the same profitability – this contributed to the great VIX blow-up of 2018.
  • Disciplined buy and hold investors, especially younger ones, should benefit as higher volatility will give better buying opportunities. A lot of the pain felt in high vol environments are when human cognitive biases result in panic selling, or not buying due to fear in the markets.
  • Some speculative assets benefit from innate high volatility, such as cryptocurrencies or penny stocks.

Who Loses From Higher Volatility?

Many more sophisticated investors look at returns through a “risk-adjusted” basis; given the same return, a portfolio with a lower volatility return profile is preferred to a high volatility strategy. This is usually expressed through the Sharpe Ratio.

  • Funds following the same strategies thus had inflated Sharpe Ratios in low vol environments that are cut back in high vol environments.
  • People who buy assets on margin lose out, as stops and margin calls get triggered and can wash out markets.
  • Assets with limited upside, such as fixed income, have more to lose if they become more volatile, particularly from a risk-adjusted point of view.
  • Investors in carry products (anything from selling options or enhancing fixed deposits) are naturally short vol and will either lose money outright or lose in opportunity cost as more can be earned doing the same strategy now than in the past

Conclusion

Volatility has become a financial bogeyman this year that has pushed many investors to the sidelines after the euphoric bull runs of the past decade. It does not have to be scary, and for many it is actually a benefit, so for the disciplined buy-and-hold investor, a higher vol environment should not affect your investment strategy.

 

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