Selling Volatility As An Asset Class

I was thinking the other day about non-correlating asset classes in order to decrease portfolio risk and even improve return, when I got curious as to whether being long volatility could be used in such a way. My theory being volatility increases in down markets when fear takes hold, which would be opposite to the market trend and would hence add diversification (or at least a hedge) to a portfolio.

My first assumption was that it would be the implementation of such a strategy that would be the most difficult part as options are a wasting asset, decreasing in value with time, and the VIX ETF is not suitable for longterm hedging (see here).

This led me to the following paper 'VIX Futures and Options:A Case Study of Portfolio Diversification During the 2008 Financial Crisis' (here). Interestingly the author did find being long volatility, via either VIX futures or 25% out-of-the.money calls,  did improve returns sometimes even with lower volatility, when added to as a 1% or 3% allocation to different portfolios.

'So what's the catch?' you are probably asking. Well the study covers a particular time period between March 2006 and Dec 2008, when there was a significant downturn and volatility spiked upwards. No strategy is suggested unfortunately in how to implement this long volatility asset portfolio allocation in preparation of such a bear market.

This however is where it gets interesting as the author refers to previous studies that suggest the following

1. Long volatility is associated with a negative risk premium, therefore over extended periods of time, long volatility positions tend to underperform the market.
2. Being short volatility should be considered an asset class and option writing strategies find excess risk-adjusted returns for short volatility positions.

Further investigation then led me to another article, this time by Blackrock called 'VIX your portfolio: Selling volatility to improve performance' (here). Here the author looks into different ways at selling volatility on the S&P500 index and shows how such a strategy would perform as a stand alone or in a diversified portfolio.

Selling volatility should capture a positive risk premium as it is said to the the same as selling insurance. Investors buy this insurance to protect their portfolios from down markets when volatility rises. The seller of this insurance (read volatility) bears the risk for protecting these portfolios so is paid a risk premium over the longterm.

Below is a graph showing the implied end of month volatility in the S&P500 from 1990 and its comparison with the realised end of month volatility. The difference is usually positive, hence the risk premium sellers receive. It is worth noting the exceptions in bear markets, such as in 2009, a time period which was covered in the first article. 

Next is a graph showing the performance of the S&P500 compared to the CBOE S&P500 PutWrite Index, a hypothetical portfolio where an at-the-money index put is sold every month. The performance details are not shown here (but can be easily found in the paper) but selling volatility in this way resulted in a higher return than the index, with lower volatility and a smaller maximum drawdown.

There are also some paragraphs on 'Avoiding blowups' and 'Risk management' that are definitely worth reading. Selling puts provides an investor with a defined and limited upside but is combined with a potential unlimited loss!

The nature of this type of investing means there are long periods of small steady wins and limited drawdowns punctuated with sudden periodic large losses. Selling out-of-the-money puts with high leverage is a recipe for disaster when the next black swan comes along. 

Selling puts for income is a strategy I have added to my portfolio over the years. I like receiving the premium and using time decay to my advantage, so it was very interesting to read that in the longterm such a strategy has the odds stacked in its favour.  

As always do not invest in anything you do not fully understand. It takes a lot of reading to understand how options are structured, how they work, the risks involved and all the possible strategies in using them.