When market volatility goes up, investors increase their investments in volatility strategies that they deem as capable of yielding the most lucrative returns. However, in volatile times the most lucrative can also be substantially risky and unstable. In this article, we will explore what strategies may help investors generate a more predictable alpha by applying a long-short volatility-based strategy.
Long short, volatility-based strategy is not just one isolated strategy, but rather a whole cluster of strategies that includes buying and selling stock and simultaneously holding long or short positions. Maintaining positions that approximately or to a large degree equate in monetary value is deemed the most accurate strategy, and, as such it has a neutral overall market exposure (S&P500, for example).
In addition, if such a strategy is focused on generating a market-neutral alpha, then this strategy can be attributed to a market-neutral approach.
A market-neutral approach is an investment that approaches a zero or zero systemic risk - that is, a beta of zero or near to zero while seeking to gain profit from at least one assumed market anomaly. A market-neutral approach can be based on different principles.
Putting in simple terms, a market-neutral strategy implies maintaining a long position on the share, bond, currency, industry, etc., which is expected to do better, and maintaining a short position on the share, bond, currency, industry, etc., which is expected to fall behind. The stocks in long and short positions usually have similar characteristics. The value of a short position is usually the same as the value or the number of stocks, bonds, currency, etc. in the long position. In theory, it is quite possible to build the portfolio with a zero-beta level - zero stock, currency, industry risk, etc., thus, making the portfolio neutral to market risk. If the anomaly turns out to be real and the portfolio is not affected by market movements, then the strategy will succeed by generating a pure alpha profit regardless of whether the market is bearish or bullish.
Alpha is usually a single number that ranges from 1 to 4, and it represents a percentage indicating the investment performance compared to a benchmark index (usually S&P-500 index). Nevertheless, such a definition of alpha is typically more applicable to the beta or smart beta approach. When we talk about a market-neutral approach, we equate alpha with the performance that is not contingent on the market overall and is uncorrelated with the market. Therefore, such a performance does not follow any index benchmark and is defined as a net gain or net loss for a specified period without reference to any index apart from such specific benchmark as market-neutral hedge fund index that can be applied as a benchmark in exceptional cases.
Bringing volatility into the equation
When investors invest in various assets such as stocks, options, and other investments, they seek to find out the probability of the price of the investment shifting upwards or downwards, leading to a profit or a loss. In the securities markets, volatility often corresponds with significant swings in either direction. For instance, when the stock market goes up and down more than one percent over a long time, it is called a "volatile" market. The volatility of an asset is a key factor for determining the prices of options contracts.
Volatility benchmarks are very helpful tools for figuring out the right strategy to manage investment portfolios, and applying these benchmarks correctly is the key to effective portfolio management.
Typically, the higher the volatility, the riskier the security. Volatility is a statistical measure of the dispersion of returns for a particular security or market index. Volatility is often measured as either the standard deviation or variance between returns from that same security or market index.
When applying standard deviation or variance to risk management, analysts intend to figure out how the annual interest rate is spread out, which gives an idea of how risky the investment is. Securities with a wider range of price shifts maintain more risk for an investor, as there is more uncertainty associated with the direction of the price.
For example, a growth-oriented stock is typically subject to sharp fluctuations with recurring spikes and reversals, and the direction of the price may be uncertain for quite some time. An investor seeking a higher return would prefer such volatile stocks since they offer a greater return potential if the circumstances are right. Pretty stable stocks carry low risk since they are likely to remain within the same price range for a long time. A stock that yields 7%-10% during a full trading year is an example of a relatively stable stock.
Variance is a statistical measurement in finance that, when applied to an investment’s annual rate of return, helps to track this investment's historical volatility. Variance is represented by σ - Sigma, and it is the main mathematic value defining asset volatility.
The term “variance” in this context refers to the extent of dispersion of the price values from the price range mean, which is calculated as the average of the squared deviation of each price value from the price range mean. The formula for a variance can be derived by adding up the squared deviation of each price value and then dividing the result by the total number of price values within the price range.
Understanding methods of calculating volatility and predicting the performance of each specific instrument allows us to create correct long-short, volatility-based investment portfolios. We should use the value at risk ratio (VaR) to determine what volatility indicators should be evaluated and what particular securities’ aspect ratios should be included for balancing a market-neutral portfolio.
Value at risk is a complex topic, and in the next article, we will focus on how understanding and utilizing such key indicators as volatility, alpha, and value at risk (VaR) enables the investor to build a market-neutral portfolio of securities with maintaining several long and several short positions.