The Benefits of Volatility Options in Equity Portfolio Management

In this post, we discuss the benefits of using VSTOXX options in portfolio diversifications. March 2010 witnessed the introduction of option contracts on the VSTOXX index, which provided investors with more flexibility for trading European volatility.

To assess the impact of adding VSTOXX options to equity portfolios, Guobuzaite and Martellini (2012) constructed a long volatility position by rolling over one month to expiration VSTOXX call options. They use both at-the money (ATM) and out-of-the-money (10% OTM and 25% OTM) calls for the analysis. Considering that volatility options are much more sensitive to changes in underlying volatility compared to fully collateralised futures contracts, 1% increments in volatility exposure are used rather than 5% increments used for VSTOXX futures (see the previous post on the same topic).

The performance of ATM VSTOXX calls provides very similar results to the VSTOXX futures. While adding a small positive exposure to the volatility index option portfolio slightly improves (1% and 2%) the performance of the overall portfolio, further increases provide no additional value. Due to increased sensitivity, the results achieved with OTM calls is much more favourable than those achieved with ATM calls; and, in the case of the 25% OTM calls, the return improvements are impressive. The performance of the portfolios with increasing allocation to 25% OTM calls is depicted in an efficient frontier form in Figure 1.

Figure 1: Impact of Adding VSTOXX 25% OTM options to Equity Portfolio in 1% Increments

In further analysis, they estimated the impact of the bid-ask spread on the performance of the diversified portfolios with VSTOXX options exposure. In this case, the drag on performance amounts to 0.53%, 4.28% and 6.21% p.a. for ATM, 10% OTM and 25% OTM calls, respectively. They also considered a classic strategy for managing downside risk in equity portfolios – the use of protective puts. In every financial textbook, protective puts are referred to as a direct hedge for the price movements in equity portfolios. In order to test this assertion, they compared the performance of an equity portfolio with VSTOXX call allocations to that of an equity portfolio mixed with long EURO STOXX 50 puts. They find that equity portfolios with EURO STOXX 50 put positions do not perform as well as portfolios mixed with VSTOXX calls. None of the portfolios with EURO STOXX 50 puts have better ‘adjusted’ Sharpe ratios than those of a pure equity portfolio. They have mostly focused on the diversification properties of volatility derivatives. However, an investor can also use VSTOXX options to trade on a specific view on the VSTOXX direction or volatility changes.

Overall, the results they obtain suggest that adding a long volatility exposure to an equity portfolio would result in a substantial improvement of the risk-adjusted performance of the portfolio. The benefits of the long volatility exposure are found to be strongest in market downturns, when they are most needed.