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lundi 28 février 2011


there has been a lot of talk recently about using volatility to hedge stock positions. Because volatility is inversely correlated to equity prices, some have suggested that it is the perfect complement to your portfolio. But recent research on the actual instruments that allow you to "buy volatility" has shown that the idea may work best in the theoretical realm. 

Retail traders couldn't "buy volatility"--at least not easily--until the products linked to the VIX futures (VIX options, exchange-traded notes, and exchange-traded funds) became available. Buying puts does get you long volatility, but the put has "path dependency," meaning that its price doesn't depend only on a given level of volatility, but on the underlying's direction as well. 

Trading volatility is one thing, but long-term investing in volatility is generally a bad idea. Volatility is mean-reverting and has upper bounds: If it goes up to 80, it will come back down to 20. You can't invest in the VIX, just in the VIX futures and associated products. But such products price in some level of mean-reversion, so when equities are rising, the futures carry premiums. Therefore, investing in such products has a negative expectation over the long run. 

Strategically buying such products can provide a nice hedge against the volatility spikes that come with equity selloffs. But owning such things long term is like owning any reasonably expensive insurance policy--it costs money. 

All of this assumes that you, as an investor, are necessarily long equities and need to hedge those positions. Such is the case of most institutional managers--but we retail traders don't have any such mandates and therefore don't have to make a long-term investment in volatility. 

That doesn't mean we can't buy volatility in the form of long calls or, even better, call spreads. That gives us a bullish position--if that is your bent--while being protected to the downside. If you are bearish you can buy puts or put spreads, or even sell call credit spreads. These are ways to hold limited-risk positions and even take advantage of current volatility conditions. 

If you don't understand the terms, but like the ideas, then its time to get to work. Yes, option trading requires work--and education. Luckily we have plenty of the latter. You have to provide the former.

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