Hedge Fund Strategies

Volatility trading

Index:

1. What is volatility? 1.1. Implied Volatility versus Realized Volatility2. Why is it so important for options trading?3. Distributional Properties of Volatility3.1. Volatility Mean Reversion3.2. Volatility Smile/Skew3.3. Term Structure of Volatility 4. Volatility Strategies in Practice4.1. Volatility dispersion or dispersion trading4.2. Volatility spread4.3. Gamma trading strategy5. References

Volatility trading

Volatility, for the most sources, is to measure the annualized standard deviation of the percentage change in the price of the underlying stock or index, in a continuously compounded basis - log return. (Marshall 2008)

1. What is volatility?

Realized volatility: measure of how volatile a stock’s price has actually been when measured over some past period of time, is a backward looking measuring. (Marshall 2008)

ppy – periods per year

Implied volatility: look to the implied volatilities at various points in time in the past, is a forward looking (Marshall 2008)

1. What is volatility? 1.1. Implied Volatility versus Realized Volatility

According Klein (2006):

constant volatilities for different options are assumed by options theory;

the volatility is similar a rough ocean with continuous waves and changing wind directions

The investor can follow the waves and use the right wind breeze to make decisions, trading gains without risking a lot.

2. Why is it so important for options trading?

Volatility tend to return to their historical averages –being mean reverting, over the long term. (Marshall 2008)

3. Distributional Properties of Volatility3.1. Volatility Mean Reversion

Volatility smile or volatility skew (Marshall 2008):

Implied volatility tends to be:

low for at-the-money (ATM) calls and puts; higher for out-of-the-money (OTM) calls and puts and for

in-the-money (ITM) calls and puts and for.

The graph: “smiling face”

3. Distributional Properties of Volatility3.2. Volatility Smile/Skew

Term structure of volatility - relationship between time to expiry and its option’s implied volatility. (Marshall 2008)

The more time to expiration -> the higher the implied volatility.

3. Distributional Properties of Volatility3.3. Term Structure of Volatility

Volatility smile/skew and the term structure of volatility combination: to develop a three-dimensional image

“volatility surface” Is a three-dimensional graph which displays strike price (volatility smile) and volatility as a function of time to expiry (term structure of volatility) for a particular underlying. (Marshall 2008)

3.3. Term Structure of Volatility

Volatility dispersion or dispersion trading:

Involves buying the volatility of the index components using at-the-money options (i.e., buying equity options) and selling volatility (i.e., writing options) on a stock index and. (Nelken 2006)

4. Volatility Strategies in Practice4.1. Volatility dispersion or dispersion trading

Volatility spread:

Involves, for example, to buy the delta-neutral number of one-year options with a low implicit volatility and, at the same time, sell short-term options with a high implicit volatility. This can be displayed via simple call-call or put-put combinations in the same basic value with the same basic price and also short and long straddles. (Klein 2006)

4.2. Volatility spread

Gamma trading strategy:

Long gamma trading strategy: is a large profit if unexpected external shocks occur, eg terrorist attacks, political elections, and environmental catastrophes. (Klein 2006)

4.3. Gamma trading strategy

Klein, H., 2006, ‘Volatility Trading’, in Eureka Hedge, viewed 2 August 2013, from http://www.eurekahedge.com/news/16_june_Davinci_Volatility_Trading.asp

Marshall, C.M., 2008, ‘Volatility trading: Hedge Funds and the search for alpha’, Dissertation, Department of Economics, Fordham University;

Nelken, I., 2006, ‘Variance Swap Volatility Dispersion’ Derivatives Use, Trading & Regulation, 11(4): 334.

5. References