What is a Long Volatility Strategy?

A Long Volatility Strategy can refer to any strategy utilized by a trader in an effort to mitigate losses and fluctuations in their portfolio due to global events and even market crashes.

Large investment firms often refer to this as hedging their investments. In this case their risk management strategy also delves deeply into diversification, in order to mitigate general portfolio changes brought on by sudden change in a single position.

Can you develop your own Long Volatility Strategy?

Many institutional investors believe that retail investors should not be allowed to trade as they do. And perhaps they are not wrong. Up to 97% of day traders lose money in some countries, and in most it is at least 70%.

This could be for a variety of reasons, but it is not viable to keep all retail investors from trading. For this reason it is important to educate people on risk management, because it is entirely possible for anyone to be able to mitigate both short term and long term risk.

There are some companies that specialize in volatility management strategies, but it is entirely possible to build your own Long Volatility Strategy.

First, let's look at how you could do that yourself.

Developing a Long Volatility Strategy

Because every person's portfolio will look different, there are a variety of different ways that they can implement a Long Volatility Strategy.

Long Volatility Strategy Using Bonds

A tried and tested Long Volatility Strategy is through diversification into bonds.

Bonds are different from stocks in terms of the fact that the company's value does not need to appreciate in order for you to make money from the bond. Instead, a bond is like a loan to the company that you are investing in, with a guaranteed rate of return over a set period of time.

Bonds are not attached to the value of the company, but instead attached to the interest rate.

For this reason, diversifying a large amount of a person's portfolio into a bond could mitigate any sudden changes in the stock market.

When interest rates go up, the price of the bond goes down. Because stock market crashes are generally paired with a decreased interest rate as government attempts to encourage recovery, this could help balance out total loss, and mitigate risk

Long Volatility Strategy Using Index Funds

For beginner or retail traders, Index Funds fight be the easiest way in which to implement a Long Volatility Strategy. Instead of investing money in a single stock, investing in an index fund is more like investing in a basket of different stocks without spending any more money.

Because it is so diversified, when one stock drastically increases or decreases, the others act as a type of buffer, preventing drastic change in the portfolio.

Common index funds include the S&P 500 which track five hundred of the US's largest companies. Simply explained, buying one S&P 500 stock is almost like buying a fraction of a sock in each of those five hundred companies.

These companies can be further whittled down, to the least volatile of them, such as in the Invesco S&P 500 Low Volatility ETF, which consists of only a hundred of the least volatile elements of the S&P 500.

Similarly, Vanguard has a Minimum Volatility ETF.

Long Volatility Strategy Using Options

A lot of people can find using options a bit complicated when building a Long Volatility Strategy, but they are very useful tools.

One of the reasons why options may be confusing is because the price of an option indicates an implied volatility, which should be used instead of historical volatility.

When the VIX rises dramatically, indicating an overall stock market increase in volatility, which would lead to an increase in option price.

There are various strategies that can be further separated when using options, but the main strategy would be to buy low, and sell high.

In other words, when the option prices are high due to temporary high volatility, then the trader might write (or sell) an option. Whereas when the market volatility is relatively low, and so is the option price, the trader might buy the option.

The Problems with the Long Volatility Strategy

The Long Volatility Strategy means that a person invests in relatively low volatility, or low risk components. However, these components are generally low reward as well. It may even lose money. A potential decrease in profits may be seen and there is no guarantee that increased volatility, such as in a stock market crash, would occur to make it worth it.

However, when trading it is important to implement risk management. So even though it may decrease profits, the slightest chance of disaster makes the implementation of a Long Volatility Strategy worth it. Additionally, it may be difficult to calculate how much one should invest in low volatility components.

For those, there are a variety of hedge fund created long volatility funds, such as the Cboe Eurekahedge Long Volatility Index, which have proven to be at least mildly profitable over the past few years, and which can at the very least be studied in order to determine which components of it might be worth investing in separately, in order to build up some sort of protection against rapid market changes.

Most traders lose money, so risk management is of the utmost importance. The Long Volatility Strategy is just one of many ways in which that can be done.

You might be also interested in What is an Implied Earnings Move? and also have a look at What is Implied Volatility Rank?