**Executive Summary **

■ Beware of “derivatives of derivatives.” When evaluating whether a given volatility strategy is appropriate for their portfolio, investors should seek to understand the primary drivers of returns.

■ Put writing strategies can deliver equity-like returns over the long term with less sensitivity to market valuations and smaller drawdowns compared to the equity market.

■ Only twice have equity valuations been higher than they are today—in 1929 and in 1999—but volatility is no longer cheap. We think this should prompt investors to look at index put writing as a substitute for equities.

**Introduction **

With the sharp rise in both realized volatility and the VIX index of implied volatility at the beginning of February, the topic of volatility trading has taken center stage. Investors have been duly inundated with commentary on volatility and volatility related products. However, among the deluge of market chatter, and plenty of confusion, we think it is worth taking a step back to consider three broader questions that pertain to the role that equity volatility can play in institutional portfolios.^{1} First, how should investors think about the plethora of volatility linked products currently offered? Second, how can investors incorporate volatility based strategies into their portfolios without taking undue risks? And third, are these strategies attractive given where we are in the market cycle? We tackle each question in turn.

**Not all volatility products are created equal **

There are, broadly speaking, two categories of short volatility strategies that are accessible to institutional investors. The first category consists of plain vanilla strategies in which the underlying asset is a standard asset, such as a broad equity index. Common strategies in this category include selling index put options, writing covered call options and selling both puts and calls (e.g., straddles). Expected levels of future volatility determine the price of the put and call options when they are sold, but the outcome of these strategies is determined by the value of the underlying equity index when the options expire.

When the driver of returns is the performance of an equity index over the life of the options, then this primary risk could be hedged with old fashioned equities. Such a strategy is only indirectly exposed to the level of stock market volatility as a secondary risk.^{2} As we will discuss below, index put writing and similar strategies are most appropriately viewed as equity replacements given their meaningful exposure to broad equity indices.

The second class of short volatility strategies includes those in which the underlying “asset” is volatility itself. Common strategies in this category include selling variance swaps and shorting VIX futures. The returns to these strategies are determined by the difference between the level of volatility when the trade is made and the level of volatility when the derivatives expire. As the profit or loss for these strategies depends on a future level of volatility^{3} of an equity index and not the value of the equity index itself, these can be viewed as derivatives of derivatives or “derivatives squared.” The now infamous exchange-traded note (ETN), which traded under the ticker XIV, was based on a strategy that combined shorting VIX futures with a very specific daily rebalancing rule.^{4}

Generally speaking, if the strategy is primarily a bet on future realized or future implied volatility, then the underlying asset is itself, in essence, a derivative. The primary risk for these strategies is changes in levels of volatility. Hedging this risk would require trading volatility directly and so the strategy is exposed to the volatility of volatility as a secondary risk. As recent events have clearly demonstrated, volatility can easily double or even triple in a single day’s trading session, exposing such products to explosive risks. It is no coincidence then that the recent rapid rise in the VIX was catastrophic for several of these complex products.