Trading volatility is much like trading any other asset. The aim is to buy low and sell high. But, by using derivatives, buyers and sellers can take a view of the likely direction of volatility: if an investor believes volatility will rise he can choose to go long volatility, if he thinks it will fall he can opt to be short.
However, in trading volatility separately from the underlying share price, what is important is not whether share price fluctuations are up or down, but by how much they move. A stock that moves 5 per cent a day is obviously more volatile than one that moves only 1 per cent a day. By choosing a future maturity date, the investor takes a view on average daily price movements from the date the option is entered into to the maturity date.
In falling markets volatility tends to increase. But volatility is different from other markets in one respect in that it tends to revert to a mean. Currently volatility is close to its historical lows. If it is very low the expectation is that it will go higher; conversely a very high level of volatility is accompanied by the expectation that it will drop.
Volatility traders on the one hand may want to protect themselves against market falls, on the other side of the deal are those investors taking on exposure to volatility in order to speculate on the market, according to their views of the likely future trend of volatility.
Falling markets
In the first case, volatility trading is often compared to insurance – insurance against market falls. Market falls are often associated with a big spike in volatility. Owning a call option on volatility if the market suffers a sharp decline could make enough money to offset or reduce the decline in value of an investor’s portfolio.
“People might have a bullish opinion on volatility or they want to protect themselves from volatility going up,” says James Bittman, senior instructor at the CBOE Options Institute. Many investors today are selling covered call options against stocks they own as a way to enhance returns or bring in income. But if volatility were to go up then the income from that strategy would be limited. VIX options can be used to protect against the volatility component of a covered-call position, by offsetting the loss of income the short options position in arising volatility situation.”
At the other end of the scale volatility trading has raised its profile in recent times in the wake of aggressive usage in speculative deals by hedge fund managers. But different investors will take varying views on how volatility will behave based on their own attitude to risk and reward. “In recent years with the explosion of alternative investments and hedge funds, which are usually associated with a more aggressive risk preference profile, there has been a considerable degree of activity in terms of taking outright views on volatility, which in recent years have been normally skewed towards expecting a lower degree of volatility,” says Luca Celati, chief executive officer and co-founder of Abraxas Capital Management.
Earning its keep
Between the extremes of protective use and aggressive use, other investors may wish to use volatility trading to enhance their portfolio returns. In fact, a view expressed by Merrill Lynch in 2004 suggested that volatility earned its place in a portfolio as an asset class in its own right with its own allocation .
“More traditional investors may use volatility as a yield enhancement on their existing portfolios more than as a way to express a very aggressive view on the markets,” adds Mr Celati.
Pricing of options or variance swaps will include elements for both historic and implied volatility or future volatility. Historic volatility, not unnaturally, is backward looking – so in pricing a 90-day maturity instrument, the volatility over the previous 90 days will be considered as an indication of the likely level over the coming 90 days. But future volatility is subject to the influence of significant forthcoming events. These may be at the macroeconomic level - a forthcoming general election, a hurricane or other natural disaster; or it could be something specific to the company, like the leverage in a company’s balance sheet (a company that is highly leveraged is subject to greater volatility risk), rumours of a merger or takeover, a litigation case facing a company, or for instance in the case of a pharmaceutical company approval of a new drug.
Traditionally, the options market has been used to trading volatility. Option prices take account of various elements – the time to maturity, dividend expectations, current interest rates, current share price and volatility. All of these elements are either known at the time the option is bought or can be hedged. Volatility is the exception.
“The way it was always traded you could buy or sell an option and you could hedge out most major aspects to it, except the volatility,” says Gerry Fowler, manager of equity derivatives research at Citigroup. “It was a matter of constantly maintaining the hedge against every other position: as the share price moved you would trade shares to maintain a zero exposure to the underlying share price movement. The profit and loss you would achieve through this process over the life of that option would show a strong relationship with the difference between actual volatility and the volatility that was originally priced into the option.”
Since the late-1990s, and with much greater liquidity since 2003, other trading instruments have hit the market, in particular variance swaps, which enable investors to buy a packaged product, isolating exposure to the stock’s volatility, with the investment bank taking over the difficult task of managing the hedging exposure.
“For the investor this is a particularly efficient mechanism because they buy one product and they are paid a return that is very closely related to volatility,” says Mr Fowler. “Producing this profit or loss is the bank’s responsibility. Because we have efficient access to markets and liquidity we can handle the hedging for them and pay them the volatility return we are trying to isolate.”
It is not just volatility in the equity market that can be traded. Any liquid market is a candidate. But there are some limitations.
Liquid market
“There are fixed income options,” says Michael Ehrat, fund manager at DFL Financial Services in Switzerland. “That is a liquid market as well, but we don’t have volatility futures, so it’s less obvious to trade volatility directly.”
The volatility of the broad market can be traded using the VIX futures and options. The VIX is a benchmark measure of market expectations of volatility over the next 30 days, derived from prices of options on the S&P 500 Index. Futures trading on the VIX index started in 2004, followed by the launch of options on the VIX in February of this year .
These new products are opening up the market for volatility trading says Bittman. “Technology and the lowering of commissions means it has now become feasible for money managers, hedge funds and individual investors to get into styles of trading that
were once the realm of the professional market maker.”
No smoke without fire over acomplia debate
The case of Sanofi is a case in managing volatility exposure. Between January and June there are significant events which will affect volatility, either positively or negatively. The first is the expected decision from the US FDA on whether to approve the weight loss drug Acomplia – on 19 February the share price fell 3 per cent, when the FDA refused approval for its usage as an anti-smoking drug, and asked for more information before sanctioning it for obesity treatment. The second is a generic challenge in court against the drug Plavis – if the company loses the case the share price can be expected to fall, if it wins the shares are likely to rise.
“So we can identify several days when we expect the share price to move more significantly than others,” says Gerry Fowler of Citigroup. “On the average day we only expect it to move 1 or 2 per cent. So people were buying volatility exposure through to June expiry and in case general volatility in the market decreased they sold volatility exposure to a longer expiry date, like December. If the general level of volatility falls they have a partial hedge for that shorter maturity exposure, but if events create significant changes in the share price on individual days the long position on shorter dated volatility will be much more sensitive and they will receive positive P&L from that.”
Another historically popular strategy has been to trade credit spreads against equity volatility. Credit spreads are a direct measure of the risk of a company going bust. So too are the price of put options as the share price can be expected to go to near zero if a company defaults on its debt.
Mr Fowler explains: “Some people would think the company might go bankrupt so would buy credit protection. But they might also be able to identify a relative overpricing in the equity put options. So by owning the CDS and having sold the equity put, and if the company goes bankrupt, they make money, and if it doesn’t go bankrupt they still make money.”
This trade was popular in the late-1990s but credit spreads now form the basis for investment bank pricing of downside put options – removing most arbitrage opportunities.
