How to trade volatility

Strategies that treat volatility as an asset class are gaining popularity, and there are plenty to choose from.

Many are active and options-based. Others are passive and intended as hedging tools. Some require clients to be accredited investors, others are prospectus-based.

We’ll look first at two active, options-based strategies, and then at a passive strategy. If you need a refresher on the basics of options, see “How options work” at the bottom of this page.

1. Not so boring

It doesn’t get any more boring than U.S. Treasury bonds, right? Not if you play volatility in the futures markets.

Levente Mady, senior portfolio manager at PI Financial Corp. in Vancouver, sells options on U.S. Treasury bond futures. His strategy, accessible to accredited investors, doesn’t follow a strict, mechanical process because there are so many variables involved in determining his outlook and how to act on it. Generally speaking, however, if he thinks the market’s likely to go up, he would be more inclined to sell puts. “If I’m neutral, I might be selling puts and calls; if I’m negative on the market […] then I would be selling calls. I’m trying to make money whether the bond market goes down, up or sideways.”

Returns come mainly from options premiums Mady collects from buyers of his puts and calls. Everything depends on how accurate his reading of the market and its future movements is. He does fundamental and technical analysis, and considers trader commitments to determine investor sentiment. “The bond market is very much event-driven, so things like Fed meetings, Treasury auctions and economic releases” provide critical clues.

He also benefits from the predictable behaviour of bond fund managers. “If you buy a 10-year bond today, that bond is going to be a nine-and-a-half-year bond six months from now. So bond portfolio managers, especially the indexers, are on a constant treadmill: on a consistent basis [they] are out there the last two, three days of the month buying more bonds to extend their terms.” In other words, they have no choice but to buy those bonds. That flurry of activity creates a predictable upward bump in the market, and Mady capitalizes on it. If the market goes the opposite direction to what he expected, he’ll try to cover losses by working the opposite side of the trade.

For instance, if he’s sold calls based on a negative outlook and the market turns positive, he’ll counterbalance his position by selling puts, bringing his overall exposure closer to neutral.

2. Puts only

If selling puts on stocks reminds you of insurance, you’re not alone. Vincent Dostie, a portfolio manager at Globevest Capital in Montreal, helps run a put-writing strategy and he sees it the same way.

“Basically what we do is sell insurance, and like all insurance we want it to expire worthless. We get premiums in exchange, and that’s our clients’ return.”

Dostie sticks to puts because losses on calls are theoretically unlimited, given that there’s no limit to how high a stock can go. Since a stock can’t fall below zero, the maximum possible loss with puts is fixed. The strategy, available in prospectus and OM versions, is to sell puts with an average maturity of one year (maturities range from six to 18 months). “We sell them at a strike level that’s at least 10% under the underlying stock price.” That 10% is a kind of safety zone: the stock price has to drop 10% before the buyer can exercise the option.

But the stock has to lose more than 10% for Dostie to actually lose money on the trade. That’s because the option premium adds an additional buffer, increasing the amount the stock can go down before he dips below the break-even point. For example, say the premium is $9 on a stock currently trading at $100. “To start losing money on this position, the stock has to drop by $10 (10%) and then you also need to lose that $9 you got upfront for selling the put option. So you’re at 19% under the market price” before you start losing money. Some of his fund’s assets are sectioned off into a portfolio of government and high-quality corporate bonds. The interest from those bonds adds to the buffer.

Something for everyone

There’s a volatility strategy for virtually every client type:

• Low-risk prospectus funds that use puts or calls (or both) aimed at buy-and-hold retail clients
• Buy-and-hold put/call strategies of varying risk levels for accredited investors
• Tactical ETFs for sophisticated clients looking to limit downside risk or shoot for enhanced returns

So, for Dostie to win on any given bet, the stock price has to go up, move sideways or fall no more than the combined total of his 10% (or greater) buffer, the option premium and the interest on the bond portfolio.

The backbone of this strategy is stock analysis. He’s not actually buying stocks (except in a case where he loses a bet and the put buyer exercises the option), but instead is making bets—in the form of puts—on their direction. “We run screens on a universe of about 1,800 stocks in North America, focusing on larger caps. We’re focused on the least risk on the downside.”

Picks that make the short list undergo further analysis and are assigned a score. “We give it a score from one to 100 and, just like in school, you need about 60% to pass. Then it becomes interesting for us. Half of that score comes from the fundamentals of the stock; the other half comes from the implied volatility. That’s the time value, or the amount of annualized returns you would get from selling that option over a year, or selling it over six months and selling an identical one over the next six months.”

Some stocks score well on fundamentals, but poorly on implied volatility, bringing the overall score below 60%. The reverse can also happen.

The majority of the stocks he writes puts on are U.S-based. “That’s where the biggest companies with the healthiest balance sheets are to be found,” says Dostie. He also has strict diversification guidelines: no single position can be more than 1.5% of the portfolio.

You may think market corrections are bad news for put writers. No so. “We like it when volatility spikes because we get better prices and premiums. If you want to profit from a spike in volatility, you sell new options.”

Dostie adds that it isn’t always necessary to buy the stock when one of his bets goes sour. Sometimes he can close out losing positions by buying the option back at an inflated price. To the extent possible, he cancels that loss out by selling new puts, which under this type of scenario (market correction) are likely commanding higher-than-normal premiums.

3. Puttin’ on the VIX

“Where’s the VIX?” is probably the most-asked question when market activity is fraying investors’ nerves.

The VIX measures the implied volatility of the S&P 500 Index—i.e., the amount of volatility the market expects over the next 30 days—as expressed in options-trading activity on that index. (Realized or historical volatility is volatility that’s already occurred.)

When the VIX is at about 15, market conditions are stable. “As it goes above 20, 25, 30, that’s when you know things are not normal,” says Vinit Srivastava, senior director of equity strategy at S&P Dow Jones Indices in New York. During the 2008 crisis, the VIX shot north of 80. “VIX, by itself, is not investable,” notes Srivastava. “If investors are looking to hedge their downside risk, or they want to take a position on volatility—they think it’s going to go up or down and they want to take an exposure one way or the other—the traded instrument is VIX futures or VIX options.” The passive option, he adds, is to buy an exchange-traded product that tracks the S&P 500 VIX Short-Term Futures Index (SPVXSP).

Steve Hawkins, co-CEO and CIO at Horizons ETFs in Toronto, warns betting on the SPVXSP can be extremely high risk and should only be attempted by sophisticated investors on a tactical basis. “These ETFs are speculative investment tools,” he says. “They are not for every type of investor.”

He notes three types of SPVXSP-linked ETFs:

• Single-up: Provides 100% of the performance of the SPVXSP, so when the index goes up (or down) 8%, the ETF holder’s units go up (or down) 8%.
• Double-up (leveraged): Provides 200% of the daily performance of the SPVXSP (exposure is reset every day), so when the SPVXSP goes up 8%, the ETF holder’s units go up 16% (losses are also doubled).
• Inverse: Provides 100% of the inverse of the daily performance of the SPVXSP (exposure is reset every day), so when the SPVXSP goes down (or up) 8%, the ETF holder’s units go up (or down) 8%.

Hawkins stresses the potential for major losses with leveraged and inverse ETFs. “They are short-term, single-day tactical tools and are not for the average investor.” But if you’ve done some serious research and your view on short-term VIX is correct, these vehicles can magnify returns for portfolios. VIX is inversely correlated with the stock market—when the VIX is going up, the market’s going down. If you think the market is set to soar, and volatility to tank, the inverse ETF can tack extra returns onto the equity portion of a portfolio. Conversely, single-up and double-up VIX ETFs can compensate for equity losses as VIX spikes.

The single-up ETF could potentially be used as a longer-term hedging vehicle. “But you have to understand the historical trend of volatility is to go down,” notes Hawkins. So, except for times when the VIX rises, exposure to a single-up VIX ETF amounts to an insurance expense.

The trick, adds Srivastava, is to “figure out how much insurance to buy.”

How options work

Options basics The finer points of options trading are highly complex, but the basics are straightforward.

Buying calls and puts

	Buying callsA call gives you the option to buy stock (or other instrument) at a specific price before a specific date. A buyer of calls wants the underlying stock’s price to go up.	Buying putsA put gives you the option to sell a stock at a specific price before a specific date. A buyer of puts wants the underlying stock’s price to go down.
Example	You buy a call that gives you the option to purchase shares of XYZ at $70 per share before December 31.	You buy a put that gives you the option to sell shares of HIJ for $100 per share before December 31.
Good outcome	The stock price jumps to $80 before December 31, so you exercise your option to buy stock from the option writer at $70. You then dump the shares in the open market for $80. Your profit is $10 per share, minus the price you paid for the option.	The stock price dips to $85 before December 31, so you go to the open market, buy the shares at $85 and then exercise your put option, which means the party that sold you the option must purchase the shares from you at $100 apiece. You’ve made $15 per share, minus the price you paid for the option.
Bad outcome	The stock dips below $70 and stays there past December 31. You let the option expire and your loss is equal to what you paid for the option.	The price of HIJ goes above $100 and stays there past December 31. The put option is worthless and expires; your loss is equal to the option’s purchase price.

Selling (writing) calls and puts

When you see references to “writing options,” it means the person is selling a put or call. The amount a person receives for selling an option is called the option premium.	Selling (writing) callsWhen you sell a call option, the buyer is paying you for the option to buy stock from you at a specific price before a specific date. A seller of calls wants the price of the underlying stock to stay the same or drop.	Selling (writing) putsWhen you sell puts, the buyer is paying for the option to sell you stock at a specific price before a specific date. A seller of puts wants the price of the underlying stock to go up.
Example	You think company WXY isn’t in as good a shape as people think. In your analysis, it’s poised to drop or, at best, move sideways for an extended period. You sell calls that give the buyer the option to purchase the stock from you at $90 before December 31.	There’s a lot of negative sentiment around PQR. The market thinks its value will drop, but your analysis suggests all the gloom is misplaced. You believe PQR’s stock price will actually go up or, at worst, stay level. So, you sell puts that give the buyer the option to sell PQR stock to you at $30 before December 31.
Good outcome	The stock drops to $85 and stays there through December 31. The option is now worthless because it makes no sense for the option buyer to purchase the stock from you at $90 when she can get it for $85 in the open market. Her loss—the option premium—is your gain.	PQR’s stock stays level for weeks and then jumps to $32 on December 31. The option is worthless as it makes no sense for the put buyer to purchase the stock in the open market at $32 and then sell to you for $30. You pocket the premium.
Bad outcome	The stock shoots up to $120 and the call buyer exercises her option to buy from you at $90 a share. You are now required to go into the open market, buy at $120 per share, and sell to her at $90. (She will then dump the shares in the open market for about a $30-per-share profit, minus the option premium cost.) Your loss is $30 per share, minus the option premium.	PQR’s stock drops to $15. The put buyer purchases the stock on the open market for $15 a share, and you are required to buy it from him at $30. You have an implied loss of $15 per share, minus the option premium. (The loss is implied because you could hang on to the shares and wait for them to recover their value.)