We all know cryptocurrency can be particularly volatile, but what does that actually mean? It turns out people have a lot of misunderstandings about volatility, and often that leads to fear. Volatility isn’t always a bad thing, especially when it could mean bigger rewards. So we sat down with an expert on volatility trading to get their professional perspective on the ups and downs of dealing with volatile assets. Here is our interview with Jeremy Wien, Managing Partner of Moo Point Capital Management, a hedge fund that focuses on volatility market trading.
Note: this interview has been lightly edited for clarity.
The concept of “volatility” comes up a lot in investing. Can you please explain what volatility means?
“Volatility” in investing refers to the magnitude of the moves in an asset, regardless of the direction; a 1% move up would be the same amount of volatility as a 1% move down would be. There are two types of “volatility” – “realized volatility” and “implied volatility.”
“Realized volatility” is the observed volatility – the actual move in a given asset’s price, up or down.
“Implied volatility” is the volatility that’s priced by the market for a given future time period, as you would see incorporated into the price of an optionA financial instrument based on the price of an underlying asset, offering the buyer the opportunity to buy or sell (depending on type) the underlying asset. Unlike other types of contracts, an option can expire unused..
How is volatility expressed?
Volatility is generally expressed as a number that represents the expected move of the asset in annualized percentage terms.
A “back-of-the-envelope math” way to convert this into something more usable is to take that volatility number and divide by 16 to get roughly the expected percentage move per day. For example, if we look at the VIX, it’s an index which measures the one-month implied volatility on the S&P 500. A VIX at 16 is roughly implying a 1% daily move (whether up or down) in the broad market; a VIX at 24 is implying roughly a 1.5% daily move.
(There is some nuance here, as the implied volatility includes a risk premiumThe return on investment an asset is expected to yield above the risk-free rate of return, usually benchmarked to the Effective Federal Funds Rate, currently 5.3%. that is charged by the sellers of options for the risk they are taking, but it’s a reasonable way to view an implied volatility number generally, whether on an index or a single asset or any other financial instrument.)
Can you please explain the connection between volatility and risk?
Volatility and risk are positively correlateda measurement of how closely the prices of assets follow one another, ranging from -1 for exact opposite movements to 1 for perfect lockstep. That means that an asset with higher volatility is generally a riskier investment than an asset with lower volatility.
Looking at specific examples in the market, ETH has a higher volatility than BTC. That, on its own, does not tell you if one or the other is a better investment or is likely to perform better over any given time period, but volatility (and the subsequent risk) should be at least one of the considerations in any investment or trade.
Let’s say I own a high-volatility asset. What exactly should I expect from it in terms of performance?
You should expect a higher long-run return. Higher volatility generally means more risk, so why should we accept more risk without expecting higher returns?
Of course, many higher-risk/higher-vol assets do not provide those higher returns, so we need to be discerning. When I say you should “expect a higher long-run return,” I mean that you should only be willing to accept higher volatility if you believe that the eventual return will be higher. Technology companies can be a good example of this. Generally speaking, technology companies exhibit higher volatility than other sectors; over the long run, in aggregate, tech has outperformed lower-volatility secctors.
Having said that, many tech companies have gone out of business (or close to it) at various times, and it can be tough to stomach 20%, 30%, 50%+ drawdowns in our investments, so we need to take all of these considerations into our investment decision-making process.
Harry Markowitz called diversification “The only free lunch in investing.” Can you explain how diversification affects risk?
Diversification reduces your risk.
If you own only one asset in your portfolio, even if it’s a great one, there’s always the risk of a bad business cycle or a “tail event” such as an accounting fraud or geopolitical issue that could result in a loss that is far beyond what you would expect or have the ability to absorb.
If you own 30 different assets in your portfolio, equally-weighted (I am not suggesting that 30 is the appropriate number of assets, OR that your holdings should necessarily be equally-weighted; this is just for the purposes of an example), and any one of those assets has a significant loss, your overall portfolio would only suffer a minor loss.
Of course, simply holding X number of different assets does not necessarily mean you are diversified; if you hold 10 different commodities or 10 different rental properties, those will often be highly correlated to one another and not offer you much diversification.
More diversification isn’t necessarily always better than less; considerations about age, investing goals, cash flow needs, risk tolerance, etc. can all impact the appropriate portfolio construction for a given investor; but generally speaking, if you have several investments that you expect to perform well over time, it would be preferable to spread your investable assets across those various investments as opposed to being concentrated in just one or two.
When regular people hear “volatility”, they often get worried or afraid. It sounds too risky for them. What would you say to people with this mindset? What does a regular person looking to invest their savings need to understand about volatility?
“Volatility” and “risk” are a part of life.
Every time we get in a car, we are taking a risk and increasing the volatility of our life expectancy.
The key is to take risks (with the accompanying volatility) that are reasonable both in terms of “expected value” and tail riskor “black swan” or “hundred-year flood.” More technically, the chance that an asset’s price will move three or more standard deviations from the mean; tail events have a large impact on returns
For example, imagine that you are offered an opportunity to flip a coin one time; for every $100 you risk, if it comes up heads, you lose the entire $100, but if it comes up tails, you get paid $200; should you do it? The answer is, “Yes, but only for x% of investable assets.” Even though your “expected value” is a +50% return (half the time you’ll lose $100, half the time you’ll make $200, so your average “return” will be $50 on your $100 “investment), you only get to do this once, so if you risk all of your capital, and you get an unlucky heads on your lone coin flip, you lose everything – that’s not a risk worth taking for most people.
Risk tolerance is very personal. Some people aspire to start a company, knowing that there’s a chance they could become quite rich and live a life of luxury but also a chance that the company ends up worthless, leaving them scrambling to find a job while having no savings and likely a decent amount of debt; other people want the comfort of a stable job with benefits and an expected salary increase of a few percent annually, enabling them to retire in relative comfort after a few decades of hard work.
One is not better than the other; they are different.
The same holds true for holding a more-risky or less-risky portfolio. There are generalizations that tend to hold true, such as the notion that younger people should generally be willing to take more risk than older people take, because the younger people have more time to make back losses that inevitably occur during various economic cycles.
But broadly speaking, “volatility” in and of itself is not to be feared – it is to be understood and considered and potentially (for those who endeavor to learn more about it and trade more actively) harnessed.
Responses above are provided by Jeremy Wien. He is the former Head of VIX Trading at JP Morgan, and is currently the Managing Director at Moo Point Capital Management. Responses are provided for informational purposes only and should not be considered financial advice.
