How to Invest in a Low Volatility Environment?

We often discuss how to use options trading strategies for hedging portfolios and investing in general.  Yesterday, we argued that the current low-volatility environment can pose significant risks to portfolios through increased position size and leverage.  So a natural question arises: can we still use options to invest in a low-risk way these days?

Before answering this question, let’s look at another article published on Bloomberg. Dean Curnutt pointed out the same problem posed by the low realized volatility, i.e. increased position size through the use asset allocation models.

Asset prices are full, but negligible volatility encourages exposure to them without any discomfort. There are losses here and there, but in general, the daily experience of mild moves is the relevant, affirming scorecard. Further, low volatility serves not as just an anxiety-reducing palliative, but also is a mathematical driver of trade sizing codified into hundreds of billions of risk managed investment strategies. Volatility control products, for example, gear up or down exposure to the equity market based on the level of realized volatility versus a preset target. Because of the diminutive daily moves in equity indices, products such as volatility control move toward their maximum long exposure. The sell signal for volatility control and other strategies like it is unambiguous: a rise in realized volatility. Stewards of capital should be actively considering the potential knock-on effects that result from contractual deleveraging triggered by the inevitable volatility spike. Read more

Therefore, in this low volatility market, short premium strategy can be dangerous. Recently, Man group CIO Sandy Rattray gave a warning

“Historically there seems to be a new group of people each time that underappreciates the very significant risks of being short volatility and wants to learn this expensive lesson.”

That “expensive lesson” can occur during a volatility spike when an overleveraged portfolio learns how sharp the two-sided sword of volatility can become. The strategy is known for generating consistent and sometimes oversized returns regardless of minor market gyrations. On a correlation matrix, the strategy appears noncorrelated, until that faithful moment of crisis hits, then an improperly leveraged portfolio with insufficient risk controls can get wiped out – and using margin, a net worth can go negative.

While some in the derivatives space have dismissed short volatility as a viable strategy, Rattray notes that, in proper doses and with risk management, the strategy [has] a place. “Shorting volatility should only comprise a relatively small part of a portfolio, and should have a clear risk-management process around it. If you don’t follow those two rules, then you could potentially end up in significant trouble,” he said. “There is no question that these short-vol strategies can pose significant risk to individual investors pursuing them if they are not managed appropriately.” Read more

So the last paragraph answers our question. We’d suggest reading it multiple times.

ByMarketNews

Published via http://harbourfronttechnologies.blogspot.com/

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About Harbourfront Technologies

We are a boutique financial service firm specializing in quantitative analysis and risk management. We combine the power of traditional structured finance with modern high performance computing in order to deliver unique solutions to our customers. Our clients range from asset management firms to industrial, non-financial companies. Visit http://tech.harbourfronts.com to learn more about us.
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