Image Source: Pixabay

Time to misappropriate some old song lyrics:

Vol is like oxygen
You get too much, you get too high
Not enough and you’re gonna die

My apologies go to Andy Scott and Trevor Griffin of the group Sweet, for butchering the lyrics to their 1978 hit “Love Is Like Oxygen.” It’s kind of sad that I remember this hit from a bygone era, especially because I wasn’t really a fan at the time. But once an earworm, always an earworm – especially when it fits with my theory that volatility is like oxygen. You can’t see it, but it’s quite obvious when there is too much or too little of it in the environment.

I recently had a discussion with two experienced market participants for an upcoming IBKR podcast (scheduled for release tomorrow) when the topic of volatility as an asset class came up. There is not universal agreement about this topic, but since one of my guests manages equity portfolios with volatility overlays, he was quite adamant that volatility is indeed an asset class of its own. 

Quite frankly, I didn’t always agree – even when I was steeped in volatility as an options market maker. To be sure, volatility was a key input to almost every one of our multitudinous calculations, but I didn’t consider it to be much more than an exogenous input. The assets were the equities, futures, and options that we traded, not the volatility which influenced their prices.

My views evolved as the suite of volatility-linked products expanded. The Cboe Volatility Index (VIX) was the first of now many practical ways to systematically measure volatility, and a whole ecosystem of futures and options on VIX and other products have since been developed. At first, I had some skepticism for options on VIX, which are essentially second derivatives. VIX is an index based on options; thus, options on VIX are indirectly options on options. It seems sketchy when I say it that way, but it’s not. Investors need to be able to express views on volatility, and products based upon VIX, VOLQ, SPIKES, and the like, have become a necessary tool.

I now like to think of financial assets like states of matter. Tangible assets like stocks, real estate, and commodities are solids. We can touch them, and we know what they look like. Fixed income and money markets are liquids. That analogy has been in place forever. We refer to short-term fixed income and demand deposits as sources of liquidity. Kind of a no-brainer, no?

Volatility is like a gas. As noted earlier, we can’t really see it or utilize it in its purest form, but it is pervasive and inescapable. If you trade options, volatility is your oxygen – it is inherent to your existence. We can further torture the analogy, of course. Low volatility means we have too much nitrogen or carbon dioxide in the mix and high volatility means we are rich in oxygen. Remember, pure oxygen is highly combustible, just like markets. Maybe exotic derivative products are plasma? I could go one, but I’ll leave it there for now.

Silly song reference or not, we now have a range of tools that allow us to invest in, trade or hedge the market’s omnipresent volatility. Serious traders should think of volatility-linked products as ways to manage an asset that we all have exposure to – like it or not. Volatility products can be used for speculation, of course, but they are really asset management tools.

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