How to Profit from Volatility

Dear Ladies and Gentlemen

My partner Mark J. Valek coined the term volatility harvesting, and after my last weekly on cryptocurrencies, I would like to offer to you, Mark’s view on how to take advantage of a highly volatile asset class and explain what is behind «volatility harvesting». Mark is head of digital assets at Incrementum AG.

Volatility

In finance, the term volatility is commonly used synonymously for the risk of an investment. The website of Investopedia describes the widely used concept as followed: „Volatility is a statistical measure of the dispersion of returns for a given security or market index. In most cases, the higher the volatility, the riskier the security.“ Needless to say, a crucial dimension of successful portfolio management is how gravely the investment returns fluctuate over the years. However, when it comes to individual positions within a portfolio, there is no need to fear volatility. Leaving regulatory aspects aside for a second, a single investment conceptionally cannot be too volatile to be added to any given portfolio what is crucial though is the correct position size. A minimal allocation of a highly volatile asset can reduce the portfolio’s overall volatility due to diversification effects. This fact is well established since Professor Harry Markowitz was awarded the Nobel prize for his Modern Portfolio Theory, which explains this.

Volatility Harvesting

However, highly volatile assets may be able to offer more than ‚just‘ diversification effects. Their volatility can be your portfolio managers ally to increase the portfolio’s returns. This can be the case if one applies a disciplined investment strategy. We call this strategy #VolHarvesting.

Step One: Rebalancing Bonus

There are two steps regarding the implementation of our #VolHarvesting strategy. The first step is via a disciplined, rebalancing approach. During the portfolio manager’s rebalancing, the portfolio manager reduces assets that have increased in portfolio size due to their outperformance versus underperforming assets. With the proceeds, he increases the positions of the underweighted assets. This process ensures that he buys low and sells high. If this approach is applied in a disciplined manner, the investor profits from the so called ‚rebalancing bonus‘. This strategy works exceptionally well if the assets that are being rebalanced exhibit high volatility and do not correlate positively.

Step Two: Selling Options

The second step of our #VolHarvesting strategy is somewhat more sophisticated. It involves the implementation of options. In the options market, one can go long and short options. Going short options is usually associated with many risks, as one sells insurance to one’s counterpart. By selling a call option, one takes on the obligation to sell an underlying asset at a specific price at a specific time in the future, regardless of what the spot price may be at that time. However, if an investor holds the underlying of the option as part of his or her portfolio, this risk is minimal, as one can sell the underlying if the call option is exercised. This strategy is called covered call writing.

Combining the two

Now let us combine the first step of our #Volharvesting strategy with the second step. If our portfolio is overweight, some assets and a rebalancing will make sense, we can sell some covered call options basically with no risk, as we are planning to reduce our asset anyway. As a seller of an option, we receive a premium. Moreover, this premium is very rich if the underlying asset is highly volatile.

We have been applying the #VolHarvesting in a fund that invests partly in cryptocurrencies and can add double-digit returns due to disciplined harvesting of the volatility. The fund was up over 80% in 2020 and so far this year is up another 15%.

Please feel free to share your ideas and thoughts with me, but please do not forget (instead of hitting the reply button) to send your messages to smk@incrementum.li.

Many thanks, indeed!

Ladies and Gentlemen, I wish you a good start into the day, a wonderful weekend, and above all, good health!

Yours truly,

Stefan M. Kremeth