When market volatility goes up, investors increase their investments in volatility strategies that they deem as capable of yielding the most lucrative returns. However, in volatile times the most lucrative can also be substantially risky and unstable. In this article, we will explore what strategies may help investors generate a more predictable alpha by applying a long-short volatility-based strategy.
Long short, volatility-based strategy is not just one isolated strategy, but rather a whole cluster of strategies that includes buying and selling stock and simultaneously holding long or short positions. Maintaining positions that approximately or to a large degree equate in monetary value is deemed the most accurate strategy, and, as such it has a neutral overall market exposure (S&P500, for example).
In addition, if such a strategy is focused on generating a market-neutral alpha, then this strategy can be attributed to a market-neutral approach.
A market-neutral approach is an investment that approaches a zero or zero systemic risk - that is, a beta of zero or near to zero while seeking to gain profit from at least one assumed market anomaly. A market-neutral approach can be based on different principles.
Putting in simple terms, a market-neutral strategy implies maintaining a long position on the share, bond, currency, industry, etc., which is expected to do better, and maintaining a short position on the share, bond, currency, industry, etc., which is expected to fall behind. The stocks in long and short positions usually have similar characteristics. The value of a short position is usually the same as the value or the number of stocks, bonds, currency, etc. in the long position. In theory, it is quite possible to build the portfolio with a zero-beta level - zero stock, currency, industry risk, etc., thus, making the portfolio neutral to market risk. If the anomaly turns out to be real and the portfolio is not affected by market movements, then the strategy will succeed by generating a pure alpha profit regardless of whether the market is bearish or bullish.