Volatility can provide a more reliable source of negative correlation in a rising short-term rate environment, providing the offset that many clients are currently looking for, especially those who may have had their fingers burnt in March 2020.
Protection against such extreme market moves has come back up the agenda in recent years, and more innovative strategies are in greater demand.
Because volatility tends to mean-revert rather than plod along a trend line, markets find it difficult to realise a very high level of volatility for a long period of time and the benefit of buying near-term protection diminishes.
Selling some options today in order to buy more options further out allows the manager to adjust for the overall level of volatility. If volatility is very low, the likelihood of it going lower is minimal. If volatility is very high, the point at which you are protected moves out a little further because the uncertainty is greater.
Volatility strategies can be constructed and applied in different ways. Implied volatility is a measure of the expected movement of an asset over a set time period in the future. Implied volatility tends to rise when markets are fearful and therefore provides a consistently negative correlation to the asset itself.
This is useful when comparing volatility and bonds where the correlation profile of bonds and risk assets can vary based on other factors such as central bank movements and inflation.
Downside protection
For example, one approach – and the one we use in the Atlantic House Total Return Fund – seeks to protect the equity exposure in a fund during times of higher market stress without sacrificing performance when volatility is low.
An underlying ‘base’ multi-asset portfolio, comprised of equities, short-duration investment-grade corporate bonds, inflation-protection assets such as gold, gold proxies or inflation-linked bonds sit beneath a rules-based volatility ‘overlay’.
This component of the fund is made up of highly liquid, low-cost options on the S&P 500 index that typically sit above the equity book.
A blend of systematic protection will shield against market falls by providing a constant level of cost-efficient exposure to implied volatility, while a signals-based component will be triggered when short-term indicators suggest volatility is likely to increase, which aims to provide a layer of protection as a significant event arises, such as the invasion of Ukraine.
Deconstructing this even further, the various inputs that go into an option include interest rates, dividends, times to maturity and volatility.
