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Making (or Losing!) Money from Volatility: Key Trends and Tactics

By David Stevenson

A small army of professional investors in the UK and around the world watch the volatility indices like hawks. These so-called vol traders have spent much of the last decade minutely examining volatility as its own asset class, constantly churning out key statistically derived observations.

If you look at these studies of volatility you soon discover that the average level for the VIX since 2004 (when the latest version of the index emerged) has been 21, while the standard deviation is about 10. These numbers imply that a move above 31 for the VIX index is a statistically significant increase in the spot price; that is, the increase is not caused by mere chance.

The same studies also suggest that spikes in volatility aren’t predictable and don’t tend to cluster for fixed periods. For instance, the VIX climbed above that significant level of 31 over an extended period between 15 September 2008 and 24 May 2009, more than eight months in total. Yet more recent spikes (in May 2010 and August 2011) have lasted between one and three months.

Volatility as an asset class in its own right seems to experience regime changes. In other words, volatility remains at low levels for extended periods of time, followed by a pronounced regime change where it suddenly increases substantially for many weeks and months.

This regime change way of looking at volatility suggests that investors can make substantial profits as markets move from a regime of ‘complacency’ (when the VIX is low) to a regime of ‘fear’ (when volatility levels markedly rise).

A spot level of 30 is a significant trigger level for the VIX index, followed by a VIX spot level of 60. Also, if the VIX index pushes above 30 a good chance exists that volatility levels remain at these elevated levels for many days and possibly even many weeks.

If you’re looking to make substantial profits from an increase in volatility (in a regime change) look at products such as geared trackers (index funds that attempt to match, or ‘track’, the performance of the index itself; in the US, 2 and 3 times leveraged trackers are popular).

Also look at covered warrants (derivatives giving holders the right to buy the underlying share at a certain price for a certain period of time) and turbos (options, specifically barrier options, in which the option is void if the price falls below the barrier level).

With these products, returns from tracking an index are amplified or geared over short and very specific periods of time; that is, the leverage effect of the product structure increases the payoff that arises from an increase in VIX levels.