While it might sound complicated, success in harvesting market volatility ultimately rests in the fundamental analysis that informs the determination of intrinsic value. Similar to an actively managed value strategy, volatility-derived alpha stems from bottom-up evaluations that uncover stocks with attractive value characteristics, strong business fundamentals and compelling catalysts to drive business momentum. The analysis in many ways is not unlike the scrutiny bond investors apply to determine the predictability of cash flows. This analysis identifies the "intrinsic value" of a given company over the investment horizon and corresponds to the level where a given stock would find valuation support even amid disappointment vis-à-vis the company's market expectations.
With a determination of a stock's intrinsic value in place — representing the price at which a company's worst-case scenarios are baked into the valuation — calls are then sold, with a strike price equal to or lower than the intrinsic value, against the security at an "in-the-money" level. Typically, the strike price ranges from 15% to 20% below a company's current valuation. The analysis, from a risk management perspective, is again akin to how fixed-income investors assess adverse scenarios to determine an issuer's creditworthiness. This structure, which is long the stock and short the "deep-in-the-money" call (typically 20% below the current stock price), effectively turns the stock into a synthetic yield structure (or bond). The resulting structure provides an implied yield often commensurate with equities, while also offering considerable downside protection and reduced volatility of returns. Additionally, the alpha (or yield) generated by the strategy is from volatility as an asset class and not from equity beta. This serves to diversify overall portfolio correlations.
To be sure, not all volatility-harvesting strategies are cut from the same cloth. Most fund managers that use equity buy/writes to manage risk and produce options-driven income will primarily apply the construct to an exchange-traded fund or index such as the S&P 500. The CBOE S&P 500 BuyWrite index is an example of this type of approach. The calls that are sold are short-dated and are "at the money." This approach offers some exposure to the broader volatility asset class, but due to the short duration and at-the-money strike prices, it offers little downside protection and little reduction in overall portfolio volatility.
Using the concept of intrinsic value; increasing the duration of the options' expiration serves to decrease the volatility of returns, increase the probability of absolute return, and deliver steady returns commensurate with equities and high-yield bonds over market cycles. The concept of "intrinsic value" imposes risk management and structural downside protection into volatility strategies and its implementation effectively allows the investor to isolate volatility as an asset class to access its benefits. Index-based strategies still give the investor exposure to volatility but do not have the same level of risk reduction, structural downside protection or diversification benefits. As such, index-based strategies are not as suited to being fixed-income replacements. Fundamentally driven volatility-harvesting strategies, on the other hand, tend to perform more like traditional fixed-income investments in that they provide a true ballast function amid excessive market swings.
Interestingly adding both index buy/write strategies and fundamentally driven volatility-harvesting buy/write strategies into a portfolio, while reducing overall equity and fixed-income allocations, should reduce overall portfolio volatility, but at the same time can maintain or increase overall expected returns, diversify alpha sources and reduce correlations.
The upshot for investors is that by focusing on fundamentally driven volatility harvesting strategies, the benefits of volatility as an asset class can be accessed. Those primary benefits are reduced portfolio volatility, structural downside protection at the position level, increased Sharpe ratio and diversification away from fixed-income and equity alpha sources.