Option premiums increase when investors see a turbulent future, but tend to be depressed when markets seem steadier and volatility levels plateau. The Pengana fund, which operates in a universe of 30-day outlooks, monitors the implied and historical volatilities of options and expects them to revert to their historical means, and places positions accordingly. This strategy contrasts with those of some other volatility traders, who form directional views on how fearful investors will be in the future. These managers would characteristically buy cheaper options when skies are clear, and sell the instruments short when conditions worsen.

In a class of its own?

Given the large premiums that options-writers can earn by holding others’ risk, and the demand they enjoy from equity and credit investors, the flow of hedging transactions which comprise the market for volatility should not abate. “Long-run returns for volatility strategies are determined by the equilibrium between the market’s desire to hedge and investors’ willingness to bear the necessary risk,” argues Goldman Sachs in a November 2007 options research paper concerning volatility strategies.

Unless the number of investors selling volatility overwhelms the demand from hedgers, the sustainability of returns for short-volatility strategies should continue. “Given the size of the long-equity community and increased cross-over activity from credit investors, we believe that would be highly unlikely,” the Goldmans researchers write. The paper argues that the flow of hedging transactions provides a market in which investors in volatility can earn passive returns. Moreover, due to the large risk premium on offer, a small slice of volatility can significantly impact returns. From January 1996 to September 2007, the authors observe that some short S&P500 variance strategies had Sharpe ratios four times that of the underlying index and beat 12 of the 13 Credit Suisse/Tremont hedge fund indices.

By providing options to investors wanting to hedge their equity and credit exposures, “selling volatility” can generate plenty of passive returns that are big enough to warrant a “non-trivial” allocation, the paper says. Selling protection in hostile markets brings returns that often beat long equity exposures, providing a diversification benefit because its drivers of return are fundamentally different to those affecting equity markets. (However, since volatility strategies feed on hedging demand, the paper suggests they should be deployed on major indices.)

Here the paper argues, as does Wilkinson, that volatility is an asset class separate to equities and deserves to be considered in an asset allocation framework. The Goldmans definition of an ‘asset class’ states that investors with a passive allocation to the asset concerned should expect their holding to outperform cash ‘significantly’ over time. Furthermore, these returns should not be dependent on the skill of the investor alone, and should also provide good diversification from other asset classes when they decline.