Volatility as an Asset Class
Despite the large number of already available financial assets, markets continue creating new ones. We see new inventions like cryptocurrencies and the DeFi ecosystem, which offer alternatives to centralized Wall Street exchanges and funds. Even older products see new iterations—in equities, one has to choose between using stocks, futures, ETFs, and more.
I can see how the common advice of passive investing led to the growth of ETFs1. But this doesn't explain why there are so many Exchange Traded Products (ETPs) that replicate the performance of assets that can be easily bought. Why would someone buy a Gold ETC instead of buying gold futures? Since I did it, I know my answer—it was easier to do with my broker. So is it just convenience? And if so, what is the price that one has to pay for it? Whenever I think about ETFs, I keep getting more questions.
One asset class that surprised me the most when I first heard about it is volatility. While cryptocurrencies have similarities with foreign exchange markets and ETPs track some combination of existing assets, volatility represents something different—market uncertainty turned into a tradeable commodity.
I used to think that it simply meant options trading, and options are specific to the underlying market. Volatility trading is much more than that; it has specific instruments like variance swaps, correlation swaps, and most importantly, VIX-related products. The VIX (Volatility Index) is central to this market.
What makes volatility particularly interesting from a big-picture perspective is that it is negatively correlated with stock index returns. If you are concerned about market crisis, this matters.
One way to hedge your portfolio is to buy put options. Depending on the complexity of your portfolio, this type of insurance might range from expensive to completely impractical to implement. Volatility offers a simpler alternative: buy VIX calls that profit directly from market fear, regardless of which direction stocks move.
This helps to answer why this market exists. People are willing to pay for insurance against wild market swings.
It seems that most profitable trading strategies in this space are focused on selling overpriced options (insurance). And indeed, you often hear about strategies like covered calls or cash-secured puts recommended as a way to earn extra income from your long-term portfolio. And that's the irony I discovered: I was drawn to volatility trading specifically for crisis protection, yet the most accessible strategies (covered calls, cash-secured puts) actually make you more vulnerable during crises. You're essentially selling insurance right when you need to be buying it.
A fascinating area that's clearly more nuanced than it first appears. The contradiction between wanting crisis protection and ending up more exposed to crisis risk suggests I'm missing something fundamental about how this market really works. I'm planning to dive deep into Natenberg's "Option Volatility and Pricing" - apparently read by almost every serious trader - and work through Sinclair's trilogy: "Volatility Trading," "Option Trading," and "Positional Option Trading." It'll be interesting to see what changes in my thinking.