Viewpoints

Volatility as an Opportunity Class

Opportunities created by volatility are likely to rise in coming years.

Is volatility an asset class? It’s a question we often debate, internally and with clients. There’s no simple answer. Either way, though, it’s anacademic point that matters less than our belief that volatility is an “opportunity class” – one with a variety of tactical and macro implications.Moreover, as financial luminaries from European Central Bank President Mario Draghi to Federal Reserve Vice Chairman Stanley Fischer have warned,volatility is likely to rise as the Federal Reserve approaches its first rate hike in almost a decade. Likewise, the opportunities created byvolatility are likely to rise in the coming years.

One of the biggest differences between investing in volatility versus traditional “one delta” assets such as stocks or bonds is that volatility investingis about more than simply reaching a final destination for price or income. Profit or loss cannot be determined simply by looking at a traditional chart.If a stock climbs from $100 to $110 over a year, its return is 10%. But if volatility increases from 10% to 11% over a year, the return may or may not be10%.

Like navigating busy Southern California freeways, volatility option trading is path dependent: Whether one makes or loses money depends on the path takenfrom point A to point B – as well as what happens en route. As with the freeways, bypassing traffic and finding an optimal route can make a big difference.As a real world example, driving to downtown Los Angeles from Newport Beach can take anywhere from 45 minutes to four hours depending on the route and roadconditions (such as, perhaps, unexpected construction). It’s a dynamic process, as volatility – or “traffic” – can create more volatility.

Another key difference is the universe of volatility investors. Volatility market participants generally fall into three categories: hedgers, yieldenhancers and relative value (RV) traders. Hedgers buy options (as a form of “insurance”) against their portfolios, which tends to push implied volatility,or the level of future volatility predicted by the option price, above realized volatility, or the actual volatility of the asset over time. Yieldenhancers suppress volatility by selling options to earn carry and add to returns. RV traders seek to identify opportunities created by the mismatch ofopposing flows of the other two. This mismatch between supply and demand occurs across the spectrums of time, expiry and underlying product.

Historically, banks acted as the “price police.” They were traditionally the biggest RV traders and thus beneficiaries of the flows and imbalances inherent in options trading. However, increased capital costs and regulation have made these once-profitable businesses lessviable.

The result: Liquidity has fallen in some markets, prompting sharper price movements and more volatility. And this has provided an opportunity for new RVvolatility investors to step in – especially investors who are more concerned with absolute returns, or alpha, than capital-cost-adjusted returns.

Classic volatility strategies

As volatility markets have evolved over the last two decades, a few trading strategies have become common. One is to sell options and rebalance a portfolioposition to limit risk (i.e., delta hedging) and capture the difference between implied and realized volatility. Generally, 3-month interest rate optionstrade at about an 8% premium to realized volatility as this is the cost of “insurance” protection (see Figure 1).

 

However – as many investors sense and most option traders have learned – tail events occur in markets much more often than normal distributions wouldpredict. Over long periods of time, delta hedging short options positions should be profitable (just ask any auto insurer) but given the potential forlosses on tail events, the size of the position versus the entire portfolio is crucial. As the central bankers have pointed out, we may be approaching aperiod of higher volatility – so one has to evaluate whether there is enough risk premium embedded into option prices to justify a short volatilitystrategy.

Another common set of strategies is employed by tail risk funds. Unlike the first class of investors who sell volatility, tail risk funds buy options inthe hope of profiting from tail events. These positions are designed to hedge portfolios and usually benefit in a “risk-off” environment. These strategiesare the opposite of delta hedging, which makes classifying and comparing volatility-focused funds difficult.

Some of the best volatility-related opportunities, we believe, are a combination of long and short volatility strategies that look to capture supply anddemand imbalances. Causes of demand imbalances include forced buyers resulting from regulation and investors protecting portfolios (hedgers). Meanwhile,supply imbalances typically emanate from investors looking for additional yield on their investments via strategies such as selling covered calls on singlestocks or investing in callable bonds (yield enhancers). These imbalances can lead to attractive trading opportunities. For example, covered call sellingcan cause single stock volatility to trade cheap to index volatility, allowing for equity dispersion trades which consist of selling index volatilityversus buying single stock volatility that represent the index.

Another tactical opportunity is beta replacement (using options to replicate a long position), as supply and demand imbalances can create much moreattractive payoff profiles than simply being long or short an asset. Structurally, there is demand for out-of-the-money (OTM) put options on equity indexessuch as the S&P 500, which causes puts to trade at a much higher premium than equally OTM calls. For example, one could buy 1.55 units of 5% OTM callson the S&P versus selling 1 unit of 5% OTM puts on the S&P 500 over a year, creating a potentially nice payoff profile for a long investor shouldthe market rise within the option time frame.

The volatility opportunity

Now, back to the question at hand: Is volatility an asset class? We believe the answer is yes – there are clear alpha-generating opportunities involatility that add diversification to investors’ portfolios across equity, fixed income and other asset classes and take advantage of naturalinefficiencies in markets.

Whereas some view volatility as simply an input or cost, PIMCO sees volatility as an opportunity class that affords portfolio managers the freedom tocreatively seek returns. We believe that by following the right directions and with careful consideration of the hazards, investors can add volatilitytrades to help reach their destinations efficiently and prudently.

The Author

Rick Chan

Portfolio Manager, Global Macro Hedge Fund Strategies

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Disclosures


The term "insurance" within this material refers to derivatives, which are not an insurance contract. Derivative instruments can be thought of as“insurance” when an investor behaves like an insurance company. For example an investor could take a derivative position to hedge a portfolio against afuture event or collect a premium when they believe an event is statistically not likely to payoff.

All investmentscontain risk and may lose value. Tail risk hedging may involve entering into financial derivatives that are expected to increase in valueduring the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe marketstress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a positioncould not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. There is no guarantee that these investmentstrategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term,especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This materialhas been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security,strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of thismaterial may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENTAUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively,in the United States and throughout the world. ©2015, PIMCO.

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