The need for non-correlated returns that are attractive on a risk-adjusted basis has never been more critical, according to Jeremy Berman and Justin Frankel, co-portfolio managers of the RiverPark Structural Alpha Fund. Unfortunately for most investors, optimizing portfolios for maximum risk-adjusted returns has become more difficult as asset classes have become more closely correlated during “tail-risk events.” The good news is that Mr. Berman and Mr. Frankel have developed an alternative strategy that seeks to capture some of the spread between implied and actual volatility – and generate returns that have a low correlation with the market.
Implied vs. Realized Volatility
Volatility measures the movement of an asset’s price, as well as the dispersion of those moves. The terms “volatility” and “risk” are often used interchangeably, and either refer to price movements up or down – however, it’s generally true that volatility is inversely correlated with gains and positively correlated with losses.
For this reason, many investors effectively “buy insurance” by gaining exposure to instruments that are positively correlated to volatility. One example is Volatility Index (VIX) futures, which increases in value along with the S&P 500’s implied volatility. This implied volatility, the very basis of the VIX, is itself based on the premiums paid for out-of-the-money calls and puts on the S&P 500 index for the current and coming month – calls are options that increase in value along with their underlying security; while puts are options that are inversely correlated with their underlying security. Thus, another way investors “buy insurance” is by buying put options on the securities they own.
Since options buying generally increases implied volatility, and increased implied volatility can in turn inspire more option buying, these investor behaviors may be self-reinforcing. For this reason, implied volatility – as measured by the VIX – is almost always higher than the actual volatility it’s supposed to imply. According to a March 2011 research report from Cambridge Associates, “implied volatility has been higher than realized volatility in 86.9% of monthly observations, with a mean difference of 4.5%,” since 1990. This means investors are “overpaying” for their insurance protection – but then again, that’s the nature of insurance. When someone buys homeowners insurance, they don’t consider it a “waste” if their house doesn’t burn down.
The Strangle Strategy
A “strangle” is a multi-option strategy that involves buying (or selling) an equal number of calls and puts on the same underlying security, with the same expiration. The idea of a “long strangle” is to capture the gains produced from volatility when you’re confident volatility will occur but you’re uncertain as to its direction.
This, however, is not the strategy that Mr. Berman and Mr. Frankel advocate. Since implied volatility is almost always higher than actual volatility, the sellers of volatility have a systematic advantage. Thus, Berman and Frankel recommend a short strangle strategy that involves short-selling calls and puts on the same security and with the same expiration date.
In a hypothetical case study, Mr. Berman and Mr. Frankel compared the returns of the S&P 500 to those of a Systematic Volatility Selling strategy from 1990 through 2013. During that time, the S&P 500 returned a compound annual 9.9%, while the Systematic Volatility Selling strategy returned an annualized 15.2% – a difference of 53%!
Short-selling options does expose investors to substantial, even unlimited risk. In their whitepaper, The Benefits of Systematically Selling Volatility, Mr. Berman and Mr. Frankel discuss Nick Leeson of Barings PLC, who nearly wiped out his firm with a bad short volatility position on the Nikkei 225. But, as the authors point out, Mr. Leeson’s use of leverage and the size of that position relative to his capital were the real culprits, not volatility selling. Options trading may not be for everyone, but a wisely implemented strangle strategy is one way investors can pursue attractive, non-correlated returns amid the current low-rate environment.
For more information, download a pdf copy of the whitepaper.