Volatility Trading : Part 1
The concepts underlying volatility trading
Volatility has taken its place as an asset class ever since mid-2000s when the first futures and options on the VIX were launched (2004 and 2006 respectively). Volatility trading was very different once these ETPs (exchange traded products) were available to trade vol on its own. The shift in trading style post-GFC, 2008, made full use of these new products and shifted away from OTC (over-the-counter) exchanges.
Today, volatility remains a hot topic. Being able to capitalise on returns despite the market conditions is an attractive feature, and given the abundance of strategies to trade vol it is unsurprising it has become an asset class in of itself.
In the first part of the volatility trading series will introduce the concepts underlying volatility, what we need to look at when thinking of strategies and the technical details.
The second part will focus on implementing these fundamentals through different combinations to take a position in the market based on your views. We will look at some scenarios to see how these strategies may be used.
What is Volatility?
Volatility is a measure of dispersion, and how large fluctuations are in market prices over a period of time
We are used to seeing swings in the price of stocks and securities. These swings are quantified by volatility. If there is a period of stable growth or decline, volatility will be low. If stock price fluctuates 10% each day, there will be high volatility.
What volatility trading does is to take a position and view on how much prices will fluctuate, rather than the prices themselves.
To make this clearer, if I think that the swings in price of a security will increase in the next week, I may take a position where I believe volatility will rise. This is called going long volatility. I may not have a view on whether the stock price will rise or fall, but that it will fluctuate, in any direction.
Long Vol - a view that volatility will increase, and so I ‘buy’ volatility now while it is low
And vice versa, if I believe a particularly stable period is coming ahead, I may think volatility will fall, in which case I would want to be short volatility. The price of the stock may rise steadily or fall steadily, but the volatility will fall.
Short Vol - a view that volatility will decrease, and so I ‘sell’ volatility now while it is high
These concepts are the same as your typical ‘Buy Low Sell High’ strategy. Think of volatility itself as the asset. When I think volatility will increase, I want to buy it while it is low and wait to sell when it has increased and is high.
Volatility and Options
There is a very strong relation between volatility and options pricing. Alongside the maturity date, strike price, underlying price and interest rate, volatility is an input into the Black-Scholes Option Pricing model.
Of all of these, volatility is special. Volatility at inception of the option contract is unknown for the lifetime of the option. The interest rate is assumed to be constant, hence that along with maturity and strike are all known. The underlying price is determined directly in the market.
But volatility is unknown. That is realised volatility. We only known realised volatility once it is, well, realised. Therefore, we need another measure to be able to determine what the volatility of the underlying will be for the duration of the option.
This is implied volatility.
Implied volatility is a prediction of volatility over a period of time.
Options are now very liquid contracts. We have market prices for all maturities and strike prices. This is the output of our Black-Scholes pricing model. To determine volatility, we rearrange the equation to solve for volatility given the prevailing market prices of options.
We essentially turn implied volatility into an output instead of an input.
Constantly using market prices to determine the level of implied volatility gives us an indication of market sentiment for volatility, which can be used to then price exotic options which are not listed on exchanges and need manual modelling.
Calls and Puts
Our vanilla option contracts are calls and puts. Calls give us the right to buy an asset, and puts the right to sell. They can be used for a directional view or a hedging trade (to offset any large movements from a previous trade).
There is a strong transmission mechanism between volatility and the price/value of call options and put options:
Call options increase in value when volatility is higher - Positive Correlation
Put options increase in value when volatility is higher - Positive Correlation
This is because when there is higher volatility of prices, there is a greater chance that an OTM call or put will finish ITM at expiration. This is because prices can fluctuate higher to push the underlying price above the strike (for a call) or below the strike (for a put).
Using Calls and Puts to Trade Volatility
To demonstrate the most simple volatility trade we can do we consider a call option:
Our view is that volatility will increase - we want to be long volatility
We know that when volatility is higher, the price of a call option will increase, all else equal
Therefore, we want to long a call option to take advantage of the future price rise
A long call is a long volatility strategy
Demonstrating this further, let’s suppose the current price of an OTM vanilla call option expiring in 3 months is $1.50. I believe in the next 2 months, volatility will increase. I will expect the call price to increase, so I buy the OTM call for $1.50. 2 months later, volatility has risen and the same call now trades at $2.05. We can sell the OTM call and make $0.55 profit.
A similar strategy can be placed with puts. Since puts are also positive correlated with volatility, if we want to long volatility we can also buy a put option. We sell this before expiration to profit on capital gain.
If we instead believe volatility will fall, and we want to short volatility, we put on the opposite trade. We can either sell a call option (overwrite) or sell a put option. The price of both these contracts should decrease, and hence a trade to sell the contracts and buy them later (short) will profit.
Calendar Timing with Options
Since options are traded with an array of maturity dates, we can use this to our advantage. We introduce calendar timing now, and will explore calendar spreads in our next article.
Let’s suppose in 14 days we have a FOMC meeting, which is likely to generate high volatility in the market 2 days either side of the date. We can use call and put options to trade off of this:
We want to be long vol to capitalise from the high volatility of the event
We want to be short vol until 12 days from now
We need 2 option contracts
One long vol option (either long put or long call)
One short vol option (either short put or short call)
We want the maturity of the short vol contract to be 11 days from now
We want the maturity of the long vol contract to be 16 days from now
What this will mean is that until 11 days, our short-vol strategy will benefit. This is just before the start of the higher-vol period due to the FOMC. From 12 days, we then only have the long-vol strategy. This will gain from the heightened vol.
This strategy could have been implemented by initially just the short-vol strategy, then on day 12 just a long-vol strategy. However, initialising both from the start provides a natural hedge. If there is high vol 10 days from now, a short-vol only strategy will erode your earnings, but with the long-vol in place as well, we reduce the downside effect through a hedge.
We hope that the differences in profit made outweighs the loss from the hedged trade, to gain overall.
Volatility Smile
An underlying asset has multiple options for different strike prices and different maturity dates. Across these options, the implied volatility of each differs. If we plot the implied volatility against strike price, and hold the maturity date constant for all the contracts, we obtain the volatility smile, appropriately named due to its smile shape.
This curve tells us that for low strike options (OTM puts - as underlying price > strike) and for high strike options (OTM calls - as underlying price < strike), the volatility is higher than for an equivalent ATM option. This means there is higher demand for OTM puts and OTM calls, and so the market is pricing in the possibility of extreme events.
Vix
The VIX is dubbed the ‘fear’ indicator, for it represents market sentiment and VERY short-term volatility based off of the SP500 index. It is generally a good measure of sentiment as seen with highs in 2008 and 2020.
We can trade volatility directly using the VIX itself. Futures on the VIX may be bought if we are long-vol, and sold if we are short-vol. Equally, we can buy options on the VIX depending on our strategy. We will explore some more advanced level strategies in the next series.
However, there are some notes to beware for the VIX:
It is a gauge of IMPLIED volatility. Realised volatility may be very different. We can trade off of the spread between the two, however this is hard. There lies a fair value gap between the VIX and realised vol, because implied vol trades at a premium.
VIX is very short-term. Short-term movements in VIX may not align with long-term expectations and hence there is a challenge in the timing of trades.
The VIX itself is very volatile, and the volatility of volatility is a complex measurement to obtain. We have the VVIX index, which tracks the vol of VIX, however this itself is NOT the expected volatility of VIX due to it being calculated using the VIX formula itself.
Next…
We will utilise the concepts from volatility trading to scenario analysis. While abstract now, they will fit in together through the various strategies we can employ with options to produce investment decisions based on individual views.