Intro

Charts and Parts made a case for “Volatility” being an asset class like stocks or bonds or even real estate. One inherent characteristic of an asset class is some type of securitization, whether a private contract or a publicly traded standardized contract traveling around the banking system. But volatility is a special asset class because the traded security is an option, a derivative contract whose value is determined by the price movement of an underlying asset. Stocks/Equity are an asset class and options on stocks are as well. A portfolio of options can be created that will produce profits if volatility rises, another one if it falls and another with elements of both. Because option prices are very sensitive to changes in the price volatility of the underlying asset, they are traded to produce volatility returns.

Options and Leverage

An option contract has a huge amount of leverage, but leverage does not have the “convexity” of options. Only options have that: multiple magnitude changes in the price/value of the option relative to the price or volatility change in the asset itself. Because of that, leveraged options risk can be high. Credit default swaps were really options and their mismanagement nearly brought down the system in 2008.

An option is the right to buy or sell an asset at a certain price over a certain period of time. If you buy a stock, you own that asset; if you buy an option on a stock, you may or may not own it depending on future events. The current price of an option is determined by the probability of future events or more accurately, the probable range of future prices of its underlying asset. This can be estimated with some math and some subjectivity by the asset’s historical volatility adjusted by some double secret sauce. It makes sense that a buyer will pay more and a seller will demand more the more the price of the asset can move. Imagine a stock at $50 and you own the right to buy it at $60 (a call option). If the stock price normally doesn’t change much you wouldn’t pay much for the option; if the stock price changes rapidly often you would pay more. The greater the volatility of an asset the greater the value of the option.

Options may be obtuse but they are everywhere in the economy and understanding how to price options can be the difference between a good deal and a bad deal.

A Real World Example

Let’s say I own 5000 acres of land and a cropper comes to me to make a deal to grow hay and split the profits. He estimates that he can produce 1000 bales of hay per crop. The current price of hay is $250 per bale and he estimates his costs at $50,000 to deliver. Total profits are  then $200,000 so we each get $100,000. But let’s say I don’t want to take the risk of the price of hay going down so I need a guarantee. The cropper being clever offers to guarantee me $50,000 no matter what and half of the difference above $300 per bale. The cropper just sold me a put option with a strike of $250 for $50,000 plus a call option with a strike of $300 per bail. Is that a good deal?

Let’s say the price of hay is very volatile and has been as low as $50 and as high as $450 per bale over the last 5 years. At $50 per bale, I make $50,000 with the put but zero without it.  At $450 per bale I make $50,000 plus $75,000 profit split for $125,000 total with the options and $200,000 without it.

But let’s say the price of hay is not very volatile where the range has been $200 to $300 per bale. At $200 per bale I make $50,000 with the options and $75,000 without them. At $300 I make $50,000 plus profit split of zero for a total of $50,000 with the options and $125,000 without them.

When hay is more volatile I do better both when the price goes down and up with the options. But when the hay price is not volatile the options do little good if any.  So the options, both put and call are more valuable when hay is volatile. It’s clear I paid too much for the put if the price range of hay is low; not so clear if the price range is high. To become more certain on pricing an option we can use better math; differential calculus will tell us more precisely the rate of change of prices over time; the Black-Sholes model will use this data to calculate a price of the option based on that range of prices.

Takeaways

So when you are “trading volatility” you are really trading options and the changes in option prices. Some day traders will tell you they trade volatility with stocks only. This is not true: they are making directional bets and can make or lose more when the volatility of the stock goes up, but they are not making a bet on volatility.

Is trading volatility an “investment” in an asset class like real estate? Maybe. I do believe that a fund that trades volatility has a place in an investment portfolio mainly because it can produce uncorrelated returns unlike almost all other asset classes today.

Disclaimer: The information contained in this article is for informational purposes only and should not be considered as investment advice. The information presented in this article should not be interpreted as a recommendation to buy, sell or hold any security or investment. Before making any investment decisions, it is important to do your own research and seek advice from a qualified professional. Investing in securities and other financial instruments carries a high level of risk and may not be suitable for all investors.