Volatility is often a big concern for investors when allocating to risky assets such as small-cap equities. I recently demonstrated how investors can mitigate risk in their small-cap allocations by utilizing strategies such as the WisdomTree CBOE Russell 2000 PutWrite Strategy Fund (RPUT).
The strategy is designed to sell cash-secured monthly put options on the Russell 2000 Index and collect premiums that act as a cushion during market drawdowns. The cost of protection—option premiums—are a function of volatility, so they tend to decline during periods of low volatility. With increasing volatility, now may be the right time to allocate to a strategy that collects option premiums.
Here I extend my previous analysis to the small-cap universe, thus analyzing both faces of volatility (implied volatility and realized volatility) to get a more complete picture.
Volatility: Implied vs. Realized
2017 was the ninth consecutive year for the S&P 500 to have delivered positive returns; the last year the S&P 500 had negative returns was in 2008.1 Market runs this long are not common—since the 1950s, there have been only two bull runs (1983–1989 and 1991–1999) of similar length as the current run. Bulls argue we are in a phase of synchronized global growth, with the U.S. leading global economic recovery and Europe, Japan and emerging markets closely following behind. As a result, the Cboe Volatility Index and Russell 2000 Volatility Index (VIX and RVX, respectively)—which are popularly considered to be gauges of investor fear and track the outlook for next 30-day volatility in large and small caps, respectively—are at their all-time lows.
Therefore, put premiums collected in any strategy like RPUT, which are priced based on the market’s forward outlook for volatility or implied volatility, should go down. Implied volatility is just one face of volatility, and to get the complete picture, we also need to see the other side, which is realized volatility or actual trailing volatility.