Equities and volatility are negatively correlated. In order to hedge the equity exposure in the portfolio, a long volatility position is necessary.

Why would a long volatility position hedge the long equity exposure?

Thanks!

C.

Equities and volatility are negatively correlated. In order to hedge the equity exposure in the portfolio, a long volatility position is necessary.

Why would a long volatility position hedge the long equity exposure?

Thanks!

C.

Because they are **negatively correlated**. Why? Because of the “leverage effect“ which means a decrease (an increase) in equity prices -> an increase (a decrease) in the company’s leverage -> an increase (a decrease) in the risk to equity holders -> an increase (a decrease) in equity volatility.

Giving you a real life example,

Let’s assume a scenario here: there’re two guys trying to hit on one hot girl. But She prefers a cocky guy but wouldn’t mind a clingy guy also.

= clingy guy

= cocky guy

At first, she gives her number to a cocky guy (Equity exposure). But she’s afraid that a cocky guy might not call her back. In her position now, she’s exposed to a cocky guy’s uncertainty. Then she’s decided to hedge out her position by giving her number to another guy which is a clingy guy (Volatility exposure).

As a result, she longs both exposures by giving her numbers to both of them. Based on her prior experience of these two types of guys, if one calls another one won’t (negative correlation). So, her role of hedging is to achieve a desired result (talking to one of them). Consequently, she mitigates specific risks in her long positions.

ha though neither the clingy, nor the cocky are OK!

So, I understand it like this: if you are long equity, and volatility increases, because equity returns and volatility are negatively correlated, your long equity exposure will suffer. So, going long volatility (and profiting from the increased volatility, e.g. through futures) will make up for those losses. Am I correct?

Thanks!

Yes yes yes

Thanks for the creative explanation though I can relate!!! Those ■■■■ cocky bastards

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Good explanation but I do not see the leverage connection here.