Investing in Volatility, to Cash In or to Hedge Bets
Published: August 12, 2011
Laura Pedrick for The New York Times
“They’re having flashbacks to 2008 at this point, so that’s not a bad deal,” said Tyler Vernon, chief investment officer of Biltmore Capital Advisors, about a strategy that limits gains and risk.
“You’re competing in a market with high-speed and hedge fund traders, and they have volatility strategies as a source of returns,” Mr. Roth said. “If you’re not developing your own strategy for dealing with volatility, you’re at a structural disadvantage on the playing field we call financial markets.”
While thinking of volatility as an investment may seem as odd as buying air rights for development once did (or still does), devising strategies that limit the highs and lows in the global economy are becoming common. They generally fall into two categories: strategies that look to profit from volatile markets and those that try to cushion a portfolio from those wild swings.
What has changed is that many of these strategies are no longer available only to the most sophisticated investors. (Some of them certainly got a lot more expensive this week.) Two of the strategies I discuss below are accessible to investors with even modest portfolios and two are for wealthier investors, but they show just how much control people can now exert on their returns.
Here’s a look at the strategies aimed at giving investors more control over their returns, though, of course, there are some risks.
COLLARS The simplest volatility strategy is combining two types of options to create a range a stock or an index will trade in. This is done by selling a call option, which allows the buyer of that call to purchase shares at a set price, and then buying a put option, which allows the person who owns the shares to force someone else to buy them if they fall to a certain level.
Take United Parcel Service, which was hovering around $63 a share on Monday, the first day of trading after Standard & Poor’s downgraded the United States’ credit rating. Tyler Vernon, chief investment officer of Biltmore Capital Advisors, which manages $600 million for wealthy families, said that an investor could have sold a call option at $65 a share for $2.50 and for the same amount bought a put option at $60. The costs would cancel each other out and the investor would have created what is called a collar around the stock.
“With volatility kicking up, this is a strategy that more sophisticated investors are taking advantage of,” Mr. Vernon said. “They’re O.K. giving up the upside after seeing markets fall down by hundreds of points every day.”
Of course, the investor may not get the gains if the U.P.S. stock rises above $65 before the collar expires. But Mr. Vernon said this was a risk most clients were willing to take. “They’re having flashbacks to 2008 at this point, so that’s not a bad deal.”
FUTURES CONTRACTS A slightly more complex but relatively inexpensive way to manage losses is to buy futures contracts that bet an index will fall in value.
Mark Coffelt, who manages the Empiric Core Equity Fund, said he hedged the entire $50 million portfolio this week by buying 702 contracts that bet the Russell 2000 index, which tracks small-cap stocks, would fall in value. They cost just $1,400. While the equities in the portfolio still fell in value, the futures contract limited the overall losses.
“Our hedges picked up $2.5 million” the previous week, Mr. Coffelt said. “Hedging has helped us tremendously this year. It has not accounted for all the gains, but it sure has reduced some of the losses.”
A big advantage of this strategy is that the markets for futures, particularly with currencies, are easy to trade in and out of. But they require restraint.
“If everything turns around quickly, we’re going to lose money, unquestionably,” said David Kavanagh, president of Grant Park Funds, which has just under $1 billion in a managed futures strategy. “I can’t emphasize the disciplined nature enough. There is always an exit strategy.”
This was an issue when Lehman Brothers went bankrupt in 2008. The firm had sold billions of dollars of structured notes that lost their value when the firm collapsed.
But investors who are comfortable with the firm creating these notes can virtually determine how much economic risk they are comfortable with by using a simple formula: the more appreciation they give up, the more they can protect themselves from losses.
JPMorgan Private Bank is selling one-year notes that offer what Joe Kenney, United States head of investments at the bank, called “contingent protection.” They have been structured to give a client as much as 20 percent gains and protect losses down to 20 percent.
On the plus side, the notes pay a guaranteed 8 3/4 percent return even if the market does not rise that much. The downside is that if the losses are greater than 20 percent, the protection expires and the investor gets all the losses.
A NEW TWIST A relatively new strategy relies on publicly traded options and exchange-traded funds to create the same effect as a structured note without the credit risk of a bank.
Mitchell Eichen, president of the MDE Group, which pioneered its “planned return strategy” in 2009, said the strategy was meant to protect against the first 12 percent of losses — with any additional losses starting at that point — and to double the market gains up to a cap of 8 to 12 percent. Now, some $275 million of the $1.3 billion the firm manages is in this strategy.
One advantage is its transparency: all the parts that create the band are held in a separate account for each investor, with Fidelity as the custodian. Another is that the firm is putting together new offerings monthly in the hope that this product will become like a laddered bond portfolio for its clients.
Philip M. Gross, a retired engineer who worked at Warner Lambert and General Electric, said he had about 15 percent of his money in MDE’s planned-return strategy and was adding to it. “If I thought the market was going straight up over the next three years, I wouldn’t do this,” he said. “But this is a practical approach.”
The one caveat with this and many of the other strategies is how they are taxed. They are often at the higher short-term capital gains rate or some mix of short- and long-term gains. But taxes are the last thing on Mr. Gross’s mind, after the market crashes in 2000 and 2008.
“I’m not sure if I’m ever going to use all my capital losses,” he said. “I realize intellectually that’s a dumb answer, but it’s a practical answer.”
Given that volatility is a practical problem right now, that may be good enough.