Volatility: The Market Price of Uncertainty by Christopher R. Cole, CFA
Founder and Managing Partner at Artemis Capital Management LLC
True knowledge is not what you know but certainty in what you do not. Volatility is simply about putting a price on that. Drawing from the famous quote by Donald Rumsfeld, former US Secretary of Defense, the trader of volatility must be able to identify “known unknowns” and “unknown unknowns” while simultaneously making a market in both.
My job as a volatility trader is to value investors’ collective fear of an uncertain future. The premise that volatility can be valued like a stock or bond is a surprisingly new and controversial idea. Advanced volatility trading seeks to arbitrage differences in the perception of variance across time, space, and asset classes in a dynamic way. Keep in mind that the valuation of volatility, like any other asset, is about the uncertainty with which market participants discount future states of the world as compared with the present. This view is true even when the “asset” is uncertainty itself.
For Artemis, the objective of volatility trading is “crisis alpha,” specifically defined as an uncorrelated return stream whereby the balance of risk and reward is skewed toward heightened market volatility without the constant negative carry associated with portfolio insurance. To achieve this end, a crisis alpha fund seeks out mispricings in the expectation of future uncertainty and may balance long volatility exposure with strategic shorts. It is important to differentiate between crisis alpha and portfolio insurance.
Although related conceptually, crisis alpha does not promise protection against every negative event, but it should also perform better than portfolio insurance in low volatility markets. The fund that seeks crisis alpha should have a positive risk-to-reward ratio overall but with the best gains reserved for market crashes, such as in mid-2011 and during the financial crisis of 2008.
Volatility and the market for uncertainty have experienced massive and wide-ranging changes since the financial crisis. Although these changes are measured using mathematics, they are entirely sourced from human behavior. Volatility traders may be known for being quantitative in nature, focusing on differential equations and exposures measured with Greek measures (such as gamma, delta, or vomma), but at the end of the day, all of that math is irrelevant if it cannot be tied back to base-level human psychology. The goal of this article is to encourage you to look at volatility in a new light and to understand how volatility markets can provide insights into behavioral economics and market uncertainty. I also want to make the point that much of what investors deem as alpha is derived from hidden volatility trading. Not only is volatility an asset class, but in fact it will be the most important asset class over the next decade of portfolio management. Many investment managers are already volatility traders; they just do not realize it yet.
Volatility, the Markets, and the Unknown
Investors cannot assume that the paradigm of lower interest rates and debt expansion that has characterized the market over the last three decades will be relevant for modeling risk going forward, nor can they find shelter in the consensus rules formed around those standards. In a world of shadow banking, the abstraction of the market has become an economic reality unto itself. Today, paradox is the new paradigm, and volatility markets are a reflection of that duality.
Imagine the world economy as an armada of ships passing through a narrow and dangerous strait. On one side of that strait is the waterfall of deflation, and on the other side is the hellfire of inflation. Volatility can be thought of as the powerful waves that could cause the ships to crash into one extreme or the other.
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