Risk is not the same as volatility, but that lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. —Warren Buffett

Joining Buffett in distinguishing volatility from risk, the late John Bogle famously said that, as volatility is a certainty, the question isn’t whether investments will go up or down, but whether investors will overreact by doing “something dumb.”

There’s a useful corollary to Bogle’s insight: Volatility is also a chance to do something smart—to harness it for gain.  

Bogle’s and Buffet’s distinctions have been lost on many investors. Ill-founded views of volatility have made herky-jerky markets intimidating for individual investors who shudder when financial talking heads somberly utter the V-word, as though it were a contagious disease.

Like many investor phobias, fear of volatility is based on misconceptions, as is fear of a good way to harness it for portfolio gains: options. This is a subject even some options-savvy advisors are so reluctant to broach with individual clients that they forgo the additional returns that options strategies can bring. Yet more advisors have been using options strategies since equity market volatility cranked up in 2018.

Volatility shows no signs of abating in 2022, as anticipated Fed actions, Omicron and other potential twists of the pandemic are likely to sustain or increase it.

There’s also a less obvious but nonetheless significant historical factor: a record of high volatility in mid-term election years. Since 1962, there has been an average drawdown of 19% in the S&P 500 in these years. But in ensuing 12-month periods, these dips have been followed by bounces averaging 32%. One of the bigger bounces—58.3%—followed a 16.6% drawdown in 1982. Another Super Ball bounce—plus 37.1%—followed a dip of 19.8% in 2018.

Swiss Army Knife
So, a focus on harnessing volatility now is probably timely. A proven way to do this effectively is to use portfolio option overlay strategies. Russell Investments calls these strategies a “Swiss Army knife, a multi-faceted tool for addressing portfolio challenges.”

Academic research shows that overlays hold significant potential for reducing risk and increasing gains. For example, researchers in a study at Monash University in Melbourne Australia looked at overlay strategies used on stocks hammered by the pandemic-induced market decline in 2020. They concluded some overlays “were able to significantly reduce the extreme drawdowns of the index in March 2020, while maintaining steady performance during the strong rebound in April.” Generally, this conclusion was confirmed by a white paper published on ETFtrends.com in April: “Regardless of one’s portfolio make-up, utilizing option overlays is one way to provide consistent income with a low probability of loss.”

Overlays can add some risk over the short term, but they can significantly reduce it over the long term (more than 20 years), through consistent defensive positions while increasing returns through monthly cash flow. Instead of a trading strategy, this is one that systematically captures option premiums through put credit-spread index positions.

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