Volatility as an Asset Class
He worries that managers who have maintained those strong returns during the low volatility period between 2013-2017, they are taking on too much risk. “The only way they have been able to do that is by ramping up their risk and when — not if — volatility increases; these are going to be the guys taken out on a stretcher. That is always the case (see Volatility cycles,” below).”
Kimple adds, “People say to us, ‘Your returns aren’t what they [used to be],’ We say that is because we are good risk managers. You have options traders that have made strong returns over the last few years because they have been taking excess risk. The canary in the coal mine for these guys is if you look at their intermonth returns for January/February 2016, August 2015 and October 2014.Their intermonth drawdowns would be very instructive and would be a bit scary.”
The options-writing strategy is more accepted by both institutional and retail, and it could be happening at the wrong time.
“My concern is if that acceptance is based on people who know what they are doing and who are able to sustain the next volatility spike?” Kimple asks. “It is frustrating that every time we’ve gotten a volatility spike it is a matter of hours or days before it is fully retraced. That is not normal, it is a direct result of central bank activity [and it] is something that can’t last forever.”
Kimple may sound like Chicken Little, but at some point the market will have an extended volatility spike, and there are more people short volatility than ever before.
“That is what is going to test the current generation of volatility traders,” Kimple says. “What happens when you have a Dow that drops 1,000 points and doesn’t bounce back and take out the all-time high, a day, a week, a month later? What happens when the market goes down and stays down?”
If we know anything about the markets, it is that it will happen. The question is when and how prepared you are for it.