I have not gotten very far into the newest installment, which features interviews with some of my favorite traders. But I have seen a number of interviews with Schwager about the book that address the idea of risk versus volatility, and it is indeed a topic worthy of further discussion.
Many people equate volatility with risk. Yet Schwager is quick to point out that such an idea is not only false, but even dangerous. When choosing a strategy or a fund to invest in, people are drawn to smooth upward sloping P/L graphs. Schwager, however, points out that those graphs often betray the real risks:
"There are many strategies that make moderate money most of the time, giving low volatility track records. Once in a while, these strategies are prone to huge losses--they are highly left-skewed. They make money most of the time, but once in a while can lose a lot. These are strategies which are explicitly or implicitly short volatility."Case in point: The least volatile investment one could have made in 2007 was in Bernie Madoff's fund, and we know how that ended. Many other funds and strategies that are not fraudulent still have low volatility that masks their true risk. As Schwager mentions, strategies that are explicitly or implicitly short volatility do just that.
Nassim Taleb discussed just this problem in "The Black Swan" and provided a nice example of low volatility and high risk in the life of a turkey, as shown on the graph at right.Many traders are drawn into option-selling strategies for just this reason. They produce steady, solid returns most of the time with the P/L in a nice upward-sloping track.
But I know of one option newsletter/auto-trade service that provides amazing steady returns and then blows up about every four years. That may be OK for hedge funds and newsletters, which make money when things are good and don't give up anything when they blow up because they can always start again. It's a different story, of course, for individual investors and traders.
I honestly don't have a problem with short-volatility strategies, as I use some of them myself. But don't be fooled by the low volatility levels, especially when looking at returns that don't include steep drops in their respective markets.
In one of the most infamous examples of this problem, Long Term Capital Management supposedly did not include 1987 in the risk models of their strategies when they blew up about 10 years later. So using protection and limited-risk selling trades is the appropriate way to approach such strategies, even if the returns aren't necessarily the most impressive.
The upshot: Don't be fooled into thinking that low volatility is low risk. And, by all means, don't be a turkey.
(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of June 6.)
