Volatility trading has grown enormously over the last few years, driven by the scarcity of conventional alpha sources and investor hunger for a source of return that is negatively correlated to equities.
As a term, however, ‘volatility trading’ embraces a range of activities. The purest way to trade volatility is through variance swaps, and there has been a surge in activity on equities and commodities, such as crude oil and natural gas. The market for structured products has also boomed. These products often start their life as a transaction developed for a particular ultra high net worth client, which is subsequently listed on an exchange for a wider market.
“The players are mainly large institutional investors, which normally use variance swaps to hedge their equity portfolios,” says Moritz Seibert, head of exotic equity pricing and structuring at the Royal Bank of Scotland.
“Some use it as an asset class in its own right, as it is uncorrelated to many other asset classes, but the main use is as a hedge. Insurers and pension funds find this particularly valuable as their liabilities are 30-40 years in the future and they need to be cautious.”
Hedge funds also trade volatility, not to hedge their portfolios, but to generate alpha. Until last year, hedge funds were generally short variance, selling variance swaps outright. In a bull market, this normally earns them a couple of basis points as the spread between implied and realised volatility comes good.
“But 2008 was different,” explains Mr Seibert. “The market for variance swaps collapsed last autumn. Lehman Brothers had gone bankrupt and all of a sudden the market became one-sided. Hedge funds needed to cut their mark-to-market losses, or they were triggered by redemptions and needed to sell – ie they were looking to buy variance.
“This would leave banks short variance. Nobody was interested in running a short variance position in 2008, as the market was very shaky and demand for protection high.
“Liquidity completely disappeared,” he adds. “More recently, liquidity has returned, but we are still waiting for increased volumes in variance swaps on single stocks. Many hedge funds have now turned their attention towards trading spreads in the variance between two indices or stocks (often in the same sector). This is to prevent too much outright exposure.”
Many traders play options on volatility indices, such as the Chicago Board Options Exchange Volatility Index (commonly known as the VIX), which measures the market’s expectation of 30-day S&P 500 volatility. The implied volatility of such indices is generally greater than their actual volatility, which means hedge fund managers who consistently sell a volatility index usually enjoy a tailwind. However, the variety of direct plays on these indices is limited.
The VIX is watched as a measure of options traders’ views on future volatility in the market, and it tends to move in a predictable relationship to the broad market so that when stocks rise, the VIX falls, and vice versa. Unlike options on stocks and indices, the pricing of options on the VIX isn’t based on the spot, or current, level, but derived from where traders think the VIX will be at expiration.
The VIX is currently trading at relatively normal levels at around 36. Traditionally, a VIX reading higher than 30 was seen to indicate elevated volatility, but from September last year through the lows in early March, the volatility index averaged more than 51, and twice hit new highs of 80-plus in October and November.
Daniel Deming, a trader at small trading firm Stutland Equities, has been trading the VIX dozens of times a day, but he says that the recent reduction in volatility has meant he has to change his strategy. “Volatility is slowly washing out of the market as the market becomes better able to digest news and gets a better handle on what the percentage moves will be,” he says.
To counter the illiquidity of VIX options, Barclays launched two iPath exchange traded notes (ETNs) over two timeframes, designed to provide access to equity market volatility through VIX futures at the start of the year.
“The advantage of these over the VIX itself is that they are easily investable and highly liquid,” says Hassan Houari, head of equity derivatives structuring at Barclays Capital. “Liquidity is provided by the sheer number of market participants trading the ETN.”
The shorter-term product trades an average of 350,000 contracts a day, or $35m (€26.3m) on average a day, while the medium-term product trades around $10m a day.
Among high net worth clients, investors who were a few months ago keen to play volatility using commodities have swung back to playing equities as well, explains Claude Schmidt, European head of equity and commodity risk management/investments for key clients and family offices at UBS Investment Bank in Zurich.
