When the Sh*t Hits the Fan All Correlations Go to One
When Markets Get Volatile, Portfolios Become Tough To Diversify
- When market volatility goes down, assets don't move around as much, and it is easy to diversify within different equity sectors.
- When market volatility goes up, a lot of stuff starts to move in the same direction that wasn't before.
- Staying small or diversifying across asset classes is the best way to mitigate getting double-whammied when markets go from a state of low IV to high IV.
When market implied volatility stays low for a while, assets that are usually correlated tend to become less correlated. That results in even lower portfolio volatility for those holding a lot of different underlyings.
Although this seems like a good thing because lower portfolio volatility is always welcome, this lower correlation does not exist when overall market implied volatility goes up.
In other words, you can think of this as the correlation between the percentage of assets that are highly correlated to each other, and market implied volatility is highly positive (as strange as that is to say). If you think of risk coming from two places: high volatility in the market as one risk, and a lack of diversification as another, those two risks increase together.
When the markets get scary, your portfolio will get extra scary because not only is everything moving around a lot more than before, but you also don't have much diversification because all the previously non-correlated stocks are now very highly correlated!
How do we mitigate this risk of stocks getting more correlated to each other?
For starters, having a portfolio that has non-equity exposure can serve you well because those assets tend to hold their non-correlation, and therefore their diversification, to your portfolio even if markets become very volatile.
Check out this Options Jive that we put together concerning the rate of correlation between different equity sectors and different non-equity asset classes.
Another way to mitigate the risk when markets get volatile is to under-allocate your portfolio when implied volatility is low. This is tough to do without some extra discipline because when markets get dull, the last thing we want to do as traders is to lower our trade sizing. Although it is akin to watching paint dry, it is the best way to mitigate risk when market volatility eventually goes back up and everything starts moving in the same direction.
Anton Kulikov has a decade of trading experience. He leads research content creation at tastylive, appears on over 20 live shows including Futures Power Hour, Options Jive, and Research Specials LIVE co-authored bestselling investment strategy book Unlucky Investor’s Guide to Options Trading, and contributes research content for Luckbox Magazine.
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