Volatility as an Asset – The Counterargument

Every investor needs to have his views challenged.  It is the best way to validate one’s views if they’re correct and it’s crucially important to figure out if those views are flawed long before the market proves you wrong.[i] 

An options market educator with years of experience as a trader, Mat Cashman of the OCC, posted a positive review on LinkedIn of my recent Barron’s guest column, Volatility Is an Asset Class. Here’s How to Manage It Without Getting Burned, even before I posted it myself.  That is more than just an ego boost – it’s validation from a respected counterpart.  But then, an old friend pushed back, writing:

               I think of it more as a risk category. Duration. Convexity. Credit. Volatility. Liquidity.

I take all respectful comments seriously, but when one comes from a very intelligent friend from college and grad school, I must admit that I take it even more seriously.  And when that commentor, Steve Switzky, used to manage billions in fixed income investments for BlackRock, I know that I’d better re-think my assertions very carefully.  

My initial response was this:

I viewed volatility that way for most of my career, but my view shifted now that there are a multitude of products that allow you to manage volatility (mostly equity-linked, to be sure). In equities, where duration approaches infinity, convexity is gamma and the clearinghouse is the only credit, it sharpens the focus on volatility. Liquidity matters to everyone.

I did note in the column that my views had morphed over time, but my friend’s comment made me realize that fixed income and equity investors are not always in synch about how they view the world.  All the risk factors that were mentioned are indeed crucial considerations for bond investors, but many of them are simply not relevant to equity investors.  (Except liquidity!  Liquidity risk is an important consideration in every investment!)

Bearing in mind that one of the reasons that my views evolved was the proliferation of products linked to equity volatility, it is understandable why bond investors would view volatility more as a risk than an asset.  There are simply fewer ways that they can treat volatility as an independent asset.

In a subsequent text exchange, my friend wrote that volatility seems to be a purer bet in fixed income.  In bonds, the response to moves tends to be more symmetrical.  In stocks, however, up moves tend to be reflected less in implied volatility than down moves.  Even though upward and downward moves in stocks have identical volatilities as measured by standard deviation, equity investors embrace the up moves.  Stocks are supposed to go up.  Upward volatility is a feature, not a bug. 

That asymmetry is what underlies the notion of “socially acceptable volatility.”  The term was originally coined by another friend, Steve Sears, the regular author of Barron’s Striking Price column[ii], and I’ve done my best to popularize (and co-opt) it.  Upside volatility is indeed something that equity investors seek.  The problem is that because volatility can and does work both ways, it can be quite difficult, yet crucial, for equity investors to manage. 

I consider myself quite lucky to be able to bounce difficult financial topics off a wide range of highly intelligent and experienced friends and colleagues.  Whether or not you agree with my assertions about volatility as an asset class, I hope you agree that it is always important to stress test your investment theses whenever possible.

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[i] That is why I encourage you to offer feedback to my work.  The IBKR Traders Insight pages now offer the ability to comment.  Please take advantage of that facility, whether or not you agree (but keep it respectful either way). 

[ii] Not all my friends are fellow Steve S’s