Academics and portfolio managers have been focusing on volatility as an asset class. More specifically, they are looking at how to harness volatility as a hedge within a broader portfolio.

In theory, volatility is the perfect alternative asset. It has low or negative correlation with traditional asset classes. It is trendless and can be six times more volatile than traditional assets, which means you don’t need much of it to hedge a portfolio.

Mind you, all these points are theoretical. They are drawn from long-term trends in the Chicago Board Options Exchange’s volatility index (VIX) relative to the performance of broad-based equities indices such as the S&P 500 composite index.

None of the theoretical applications account for real-world constraints. Take, for example, the iPath S&P 500 VIX Short-Term Futures ETN (VXX), which purports to track the VIX. Over the past year, VIX has been flat. But over the same period, the Nasdaq 100 volatility index (VXN) has lost more than 50% of its value!

The real-world constraints reflect the cost of holding a basket of volatility futures contracts expiring within the next two months. To maintain the appropriate balance across volatility expiration cycles, VXX managers engage in a daily ritual of rolling a percentage of the portfolio from front to back contracts. That trading can be a costly exercise, as indicated by the disparity in performance.

However, that does not dispel the value of volatility as a hedge. It only indicates that there might be other, more cost-effective ways to harness volatility.

When you think about VIX, it is an index that measures the volatility being implied by options on the S&P 500 composite index. Stated another way, it measures the cost of an S&P 500 “straddle.” A straddle involves the purchase or sale of a call and a put with the same terms. At the time of writing, the S&P 500 Depositary Receipts (SPY; US$131.56) June 131 calls were US$3.50, and the SPY June 131 puts were US$3.70. This gives the straddle a value of US$7.20.

The buyer of a straddle is not concerned about direction, only that SPY moves up or down by more than US$7.20. Effectively, then, the straddle frames a trading range for SPY, which in this example, is US$138.20 (US$131 strike plus US$7.20 premium = US$138.20) to the upside and US$123.80 (US $131 strike less US$7.20 premium = US $123.80) on the downside. Think of this “implied” trading range as the “implied” volatility being priced into SPY options.@page_break@Following the hedge theory, think of the SPY straddle as an alternative to VXX. The straddle is not affected by the daily roll that haunts VXX. But the straddle is subject to time-value erosion, which chips away at the premium as the straddle moves toward expiration.

The straddle does not require a big money outlay, probably no more than 5% of the total value of the portfolio. This is particularly so when volatility is stable — say, VIX between 15% and 17%.

If the market were to decline sharply, which would negatively effect your clients’ equities assets, the value of the SPY straddle should spike, based on the rise in volatility. For example, at US$7.20 per straddle, the volatility being implied is approximately 16%. A volatility spike to 25% would value the straddle at US$11 (all other factors remaining equal).

Other advantages worth noting include how the straddle is affected by a directional market move. If the global markets were to decline significantly, the straddle would not only profit from the increase in volatility, but would also profit on the movement in the underlying security.

Another positive is that the SPY straddle is in U.S. dollars. In any sell-off, the US$ is likely to rise. In a panic sell-off, the US$ would take on its traditional role as the currency of last resort.

The risk is that markets remain in a tight trading range. The worst case, although it is not very likely, would see SPY close at exactly US$131 at expiration. In that case, both options would expire worthless and you would lose the entire cost of the straddle.

The pros and cons of this strategy hinge on its use as a hedge. Your clients should not be committing more than 5% of their total portfolio to the hedge. In a broader portfolio, the straddle hedge should take some of the edge off their equities exposure. This would allow clients to overweight blue-chip stocks and, conversely, underweight fixed-income.

That is not a bad trade-off in a low interest rate environment, coupled with the real possibility that rates will rise over the medium term. Should the market remain stable, then blue chip stocks should retain their value and even grow slightly. In an ideal world, that would erase any of the costs associated with the hedge.

At least with the straddle, your clients benefit from an expansion in volatility, a move up or down in the U.S. stock market and a flight to quality into US$.

In short, the straddle may be the ideal way to harness volatility as an alternative asset class. IE