Understanding Volatility, A Powerful Asset for Downside Protection

Although they are often used synonymously; volatility and risk are not the same. Volatility is a measure of how much an asset value moves and is impacted by economic conditions. Volatility plays an especially important role in investing, risk management and asset pricing.

Mehdi Sagid

  • 5 min Read

Volatility is often used as a measure of risk and shows the intensity of fluctuation of individual stocks, indices or other underlying instruments around their average value. The higher the volatility, the more the price moves up and down and the riskier but also more promising the investment. Investors use volatility as a proxy for risk, something by which they can identify changing patterns or movements and can therefore use when making investment decisions, particularly where specific risk tolerances are at play.

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A period of low volatility does not mean that investing is low risk. In fact, the opposite can be true. At a macro level, one current concern is that investors take excessive risks when volatility has been rather low, because it tends to mean that market movements – upside and downside – are low and therefore the opportunity to make gains has been reduced. This results in higher potential tail risks. Also, over time specific market risk tends to revert to the mean: so, if it goes through a period of low volatility, at some point volatility will increase to compensate for that, and vice versa.

Volatility as an asset class

Volatility is increasingly seen as an opportunity to diversify returns and there are several approaches to “investment volatility”, which allow for it to be treated as an asset class. Usually, these kinds of strategies try to earn the risk premium by being short volatility. However, there are multiple different ways to implement it. A common investment is shorting VIX Futures (on implied Volatility of S&P 500 Options).

By being short implied volatility, the majority of volatility funds usually try to earn a risk premium which generates returns in stable market phases but can sustain substantial losses when the equity market declines sharply.


Inversely, by being long implied volatility, Equity funds hold an “insurance” against market selloffs but sustain a constant cost during market low volatility phases. Being situationally long implied volatility in certain market conditions is an optimal and more efficient solution we offer at Quantumrock.

Why does equity implied volatility display put skew?

Empirical studies have shown that the rate of return for equities do not follow a normal low but displays leptokurtosis, so called fat tails, that leads to a volatility smile.

Volatility skew (put skew) is the result of the asymmetry between long vs short positions in the equity market. Most of the market participants are long equity and the fact that the market tends to trend up with lower volatility and corrects downwards quickly with higher volatility. There is, therefore, a higher demand for downside protection out of the money puts.

Low volatility regime

Since the financial crisis of 2008, we have entered a new era. The biggest central banks in the world (FED, ECB, etc.) intervened with an unprecedented accommodative monetary policy, introducing quantitative easing, negative rates, and strong forward guidance. The impact on volatility has been significant as we entered a new era of low volatility, which became the norm in all asset classes. Given the low-interest rates around the world, the low volatility in the equity market and the central banks strong monetary policy, institutions had no other options than to invest massively in equities.

Downside protection

The COVID-19 crisis has exposed market vulnerability and a paradox. The VIX is historically at its lowest level, suggesting a low level of interest for downside protection, a market where most investors are long equities and not as sensitive to risk given the central banks support. The perfect recipe for disaster.

The classic methodology, among others, to hedge an equity portfolio is to buy put options in the benchmark index or keep a long position in the VIX future. This is unfortunately not always the best option as it relies on very high cost and management.

At Quantumrock we have a unique approach to provide equity downside protection. We use advanced machine learning and AI technics as well as inhouse algorithms that monitor and predict surges in the S&P 500 implied volatility. This gives us the capacity not only to protect our investor’s assets at low cost, but also to generate alpha consistently during periods of either high or low volatility.

 

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Glossary

  • Risk premium – A risk premium is the difference between the risk-free interest rate and the expected total return on investment. The higher the risk of an investment, the higher the risk premium must be.
  • Leptokurtosis – Leptokurtosis is the distribution with positive excess kurtosis. Compared to the normal distribution, these are more pointed distributions, i.e. distributions with strong peaks and fatter tails.
  • Out of the money puts - An out of the money put is an option with a spot price of an underlying asset above the strike price. The option therefore has no intrinsic value at this time.

 

Photo by Jared Arango on Unsplash