How can I make a profit from investing in volatility?

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How can I make a profit from investing in volatility?
The Bank of England announced its latest interest rate decision on May 4 in its fight against inflation. (Hollie Adams/Bloomberg)

A blend of systematic protection will shield against market falls by providing a constant level of cost-efficient exposure to implied volatility, while a signals-based component will be triggered when short-term indicators suggest volatility is likely to increase, which aims to provide a layer of protection as a significant event arises, such as the invasion of Ukraine.

Deconstructing this even further, the various inputs that go into an option include interest rates, dividends, times to maturity and volatility.

Volatility can provide a more reliable source of negative correlation in a rising short-term rate environment. 

In isolating volatility as an input, expectations can be set over whether it will go up or down (implied volatility), which in turn will enable proxies to be created and allow it to be traded. 

As an alternative strategy to a traditional multi-asset fund, rather than relying on the twin returns from the fixed income element, investors could seek the income or coupon-bearing element from the underlying equities and the duration element from the volatility overlay.

Such strategies are designed to protect the ‘tails’ in extreme times while offering greater downside protection in more typical conditions.

Striking that balance can be likened to an insurance policy. Paying a higher excess on your car insurance policy may feel more expensive to deal with small surface scratches but if you write the car off, those higher excess premiums will bring down the cost of replacing the car altogether.

Applying that to the options market, selling some protection that is closer to where things are today will allow the fund manager to buy multiples of that protection should the market move further out in future. The overlay will not necessarily 'kick in' unless it is really needed; taking effect at times of significant market moves rather than gentle bumps in the road. 

Specialist fund managers, skilled in managing volatility and turning it into a positive part of your portfolio, will be best-placed to meet this shifting demand as they seek to deliver predictability and diversity of returns while mitigating equity risk during times of market stress.

Tom Boyle is manager of the Atlantic House Total Return Fund