Volatility in the equity market has returned in 2018, particularly compared to last year’s calm markets. When volatility increases investors face a conundrum: try to ride out the market swings or sell to reduce equity exposure. Neither tends to be a good option. Trying to ride out the market volatility puts investors at risk for significant losses. And lowering equity exposure reduces risk but sacrifices significant upside gains should the markets start to rise.
A downside protection strategy
Utilizing asset allocation and diversification is not enough during times of market stress. These solutions tend to fail because asset classes tend to drop together during large downturns. Investors need to seek and evaluate other risk control solutions – specifically, those that focus explicitly on downside protection.
One such downside protection strategy involves investing in products that provide exposure to volatility itself. While volatility is a statistical measure that indicates how much the markets fluctuate, it is possible to “invest in volatility” to realize gains when market volatility increases and vice versa.
Investing in Volatility through options
The purchase of S&P 500 Index options is one approach to invest in volatility, also known as being “long” volatility.1 Increased volatility makes options more valuable by raising the chances of the option being “in the money.”
Implied volatility reflects the market’s perception of the future volatility of the option’s underlying security (i.e. the S&P 500 Index). Implied volatility is embedded in the price of the option – it is a key variable that determines the option’s price. In general, volatility increases as markets decline which typically causes observed implied volatilities to increase as options become more valuable.
Buying options to achieve an investment in volatility can provide valuable protection against downturns but options will also decay in value simply with the passage of time. Implied volatilities can also decline during periods of rising, low-volatility equity markets. The key requirement to implementing downside protection is appropriate sizing and seeking a good balance between (i) providing meaningful protection in downturns and (ii) anticipated costs in stable or rising markets.
Disclosure: AnchorPath maintains long volatility exposure through portfolios of index-based S&P 500 options in its fund strategies.
1 Capturing the pure volatility aspect of the index option purchases requires hedging the other pricing variables such as movements in the S&P 500 and interest rates.
2 The change in implied volatility is an approximation that reflects the change of the implied volatility of an S&P 500 Index option that when purchased had a 2-year expiration and strike equal to the S&P index, referred to as at-the-money.
3 The S&P 500 Index options had a 2-year expiration and an at-the-money strike.
Past performance is not a guarantee of future results. This material is not intended to be relied upon as a forecast, research or investment advice. This material is not an offer, solicitation or recommendation to buy or sell any securities, products or services or to adopt any investment strategy. The material is subject to further review and revision. Opinions expressed are as of July 2018, may change at any time for any reason and the author’s opinions do not necessarily reflect the views of AnchorPath Financial, LLC.
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