Volatility: Finally Getting Respect

By STEVEN M. SEARS

SINCE DERIVATIVE PRICES REFLECT the probabilities of potential outcomes, Striking Price commemorates the end of 2007 with a prediction for 2008.

After so much sturm und drang in the global markets in 2007, investors increasingly will view volatility as an asset that can be traded, just like stocks and bonds.

This view has long been touted by options pros, but now it's being bolstered by a Goldman Sachs research paper recently distributed to clients. In it, options strategists Maria Grant and Krag Gregory argue that stock volatility is an asset class, and that investors should commit money to it when they make asset-allocation decisions.

In their research, they found that:

• Selling index volatility offers significant, passively generated returns, and that big investors must buy options to hedge their positions.

• Returns are large enough to justify a substantial allocation to volatility.

• Volatility selling tends to outperform long equities in hostile markets, offering diversification benefits.

One problem in viewing volatility as an asset class is that it's hard to model; data is scarce beyond the Chicago Board Options Exchange's Market Volatility Index (VIX). But Goldman has developed a "risk-equivalent portfolios" methodology that lets investors create volatility positions sized to meet specific targets.

Grant and Gregory say an asset class is defined by expectations that a passive position in it will produce significant returns above cash over time. Additional determinants include long-run returns that don't depend on investment skill, and diversification benefits in unfavorable markets.

Anyone with a basic understanding of options can benefit from volatility.

While Goldman's research shows that sophisticated variance swaps generate the highest returns, basic options strategies also work well. Put selling and strangles selling beat call selling against stock, a strategy that has emerged as a mainstay in the options market.

"Selling at-the-money straddles 12 times per year generated significant income, with an average monthly premium of 3.7%, resulting in 69% of months having a positive strategy return," Grant and Gregory write. However, selling 1% out-of-the-money strangles had the highest annualized return: 11.2%. Selling covered calls against stock produced the lowest risk-adjusted returns. The average monthly premium collected was about 1.9%, and the calls were exercised more than half the time.

"Investors woke up this year and realized every strategy they had was short volatility," said Mark Neuberger, a portfolio manager at Titan Capital, "and they've been assessing this ever since,"

It is likely that academics and other strategists will now produce reports that examine Goldman's asset-class assertion, lending critical mass to a theory that could have a significant impact in 2008 and beyond.