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Volatility As an Accidental Asset

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BlackRock (BLK) is receiving some attention today for two recently published reports, both of which focus on the idea of volatility as a distinct asset class. This is already a well-explored idea: to give just two examples, Nelken 2007 was the first book-length treatment, and I did a survey of some of the academic literature in my 2011 essay. But as Sears explains, as the world's largest asset manager, BLK obviously has a bigger megaphone with which to communicate this important concept to investors.

When we talk about trading volatility directly, the conversation often turns to complex products like CBOE Volatility Index (VIX) futures and options or over the counter variance swaps. It's worth remembering that to trade volatility, you don't need to trade in anything esoteric. Every transaction in puts or calls, after all, expresses a view about volatility, such that even the most familiar uses of options -- like covered calls and married puts -- are actually ways of adding the volatility-as-an-asset theme to your portfolio. Investors often think about selling covered calls as a way of adding "income" to a stock portfolio, but it would be more accurate to describe call selling as a short volatility strategy.

This also serves as a reminder that there are really only two kinds of reasons to use options in a transaction: for the leverage, or to express a view about volatility. The latter sort of reasoning is what options are best suited for. As for the former: no investor ever became successful just because she levered up, while plenty of firms and investors have failed after using excessive leverage. So when you see a writer or commentator recommending the use of options for some trade, ask yourself whether volatility is an essential part of their analysis. If not - if, for instance, it's just a directional bet with added leverage - think twice before following along. Volatility is a valuable asset, but only if you trade it on purpose.

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