Investors View | Carl Mason, Seth Weingram | Deutsche Bank

Volatility trading hedge funds: A Primer

By: Carl Mason and Seth Weingram | Equity Derivatives Strategy Group, Deutsche Bank Securities Inc. | New York Introduction Most investors have traditionally considered volatility a characteristic of other assets, such as stocks or bonds, but not as an asset to be traded in its own right. Even those who trade instruments whose valuations significantly depend on volatility, such as convertible bonds and options, havent, in general, thought of volatility as a basis for a dedicated investment strategy. Over the past few years, however, volatility trading has become increasingly popular due to a combination of factors. Interest in speculating on or hedging against volatility in-creased as investors watched equity market volatility undergo tremendous swings starting in the late 1990s. (See Figure 1) In recent years, the hedge fund community, faced with inflows of capital and a perception that opportunities offered by some traditional strategies have diminished, has turned to volatility trading in its search for new sources of alpha. As well, volatility trading is easier than it has ever been. Data needed to trade volatility has become increasingly available, technology to manage volatility risk

has become more accessible, and option dealers and exchanges have introduced over-the-counter (OTC) and listed products respectively that allow investors to express views on volatility in a purer and simpler form than they ever could have before. In fact, many have come to consider volatility a new asset class. In this piece, we discuss why volatility trading can exist as a viable, sustainable strategy for the hedgefund community, we describe methods and strategies that hedge funds use to trade volatility, and we conclude with a discussion of key issues facing volatility traders today.

Why can volatility trading be a viable hedge fund strategy? Volatility traders search the market for options that appear mispriced in volatility terms. Volatility is one of the most important factors affecting the price of an option. For reasons discussed shortly, the volatility input that is relevant to an options price should be related to forward-looking expectations of the underlyings volatility over the options life. Given the market price of an option and a few assumptions, we can back out the level of volatility used to price the option. We call that number an implied volatility. To understand why volatility trading could be a sustainable, profitable strategy for hedge funds, we first need to examine

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Investors View | Carl Mason, Seth Weingram | Deutsche Bank

Figure 1 | S&P 500 Realized Volatility (3M)

45% 40% 35% 30% 25% 20% 15% 10% 5% 0%
Jan 90 Jan 92 Jan 94 Jan 96 Jan 98 Jan 00 Jan 02 Jan 04

Source: DBSI estimates and calculations, FAME, Reuters

the structure of the options market. Consider a simplified picture: A broad set of investors buys options from and sells options to a community of dealers. These endinvestors trade options to express directional views on underlying stocks and indices. As examples, equity fund managers buy puts to hedge their portfolios, and retail investors buy securitized products that contain embedded options. When a dealer buys or sells an equity option, it wont usually take a directional bet on the underlying specifically, the opposite of the directional bet that the enduser takes. Instead, the dealer immediately hedges out its directional exposure to the underlying stock by buying or selling shares. As soon as the underlyings price rises or falls, though, the dealer must adjust its hedge to keep itself neutral to the directional movements of the stock. This is because the value of the option is curvilinear with respect to the underlyings price, so its sensitivity to stock price movements changes as the stock rises and falls. Through this rehedging process, called delta-hedging, the dealer continually buys and sells shares. Delta-hedging eliminates the dealers exposure to the directional movement of the stock, but it introduces exposure to the stocks day-to-day volatility. As it turns out, when the dealer buys options (whether calls or puts), it ends up being long volatility. The dealer earns more through its deltahedging activity as volatility rises. When the dealer sells options, it ends up being short volatility. The dealer earns less through its delta-hedging activity as volatility rises. In the market described above, option dealing isnt a zerosum game. A customer may wish to buy a call because hed like upside exposure, but he is too concerned about downside risk to want to buy stock. The option dealer may happily sell the option because she expects that realized volatility will be lower than the implied volatility reflected in the options price. At option expiry, both the option buyer and

the option seller can end up benefiting from the trade, because theyll evaluate it based on different criteria. The customer cares about the options payout, which depends only on the stocks price at expiry. The dealer cares about her delta-hedging p&l, which depends on the stocks dayto-day volatility during the options life. In this way, option dealing can create value within this community of dealers and investors. Volatility trading hedge funds behave much like the option dealers described above. They trade options based on volatility, buying options when volatility appears cheap, and selling options when volatility appears expensive. If there were no other option users in the market, then volatility trading would, in a sense, be a zero-sum game. Volatility traders would win only at the expense of the dealers. But the presence of investors in the market who value options based on criteria other than volatility provides opportunities for both option dealers and volatility traders. The volatility trading community actually helps dealers do business with customers who arent volatility sensitive by providing liquidity in situations where an excess of supply or demand pushes option prices away from levels justifiable on a volatility basis as dealers approach their risk limits. In return, the volatility traders get to trade options at levels they should find attractive. In this scenario, volatility traders play a key role in helping the option market function. Intuitively, therefore it would seem that volatility traders could have profitable opportunities as long as there remains a reasonable balance between the number of investors who use options for purposes other than trading volatility, the size of the dealing community, and the size of the volatility trading community.

Figure 2 | Theoretical sensitivity of a call option to its underlying stock at some time prior to expiry

Option Price

Underlying Stock Price

Source: DBSI estimates and calculations

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Strike Price

Investors View | Carl Mason, Seth Weingram | Deutsche Bank

Volatility trading methods and strategies How, in practice, do volatility traders express views on volatility? Trading options outright The most common method of trading volatility is to integrate a view on volatility into the expression of a directional view via options. Funds that employ these strategies are often research-driven. They look for option strategies that are consistent with their fundamental, directional view on the stock, and that also seem to offer a volatility-based pricing edge. For example, if you think that a stock you own is going nowhere fast, then consider selling an out-of-the-money call option against your holding. You may think the stock is un-likely to rally up to a particular strike price, in which case youll augment your return with the premium taken in for selling the call (if you are wrong, and the stock trades above the strike price at expiry, you will be bound to sell stock at the strike price, incurring a loss in excess of premium). Given your view that the stock isnt likely to move much, you may think that implied volatilities look high, and so you may be predisposed to sell options on this name. Delta-hedging options Trading options outright does involve a volatility component, but it doesnt give you exposure to the day-to-day volatility of the underlying. The payoff from trading an option outright only depends on where the stock price is on expiry day it doesnt depend on the volatility of the path that the stock price takes to get there. To obtain exposure to the day-today volatility of a stock you could delta-hedge an option, as described previously. Selling options and delta-hedging is a way to express a view that future realized volatility will be lower than current implied volatility. Buying options and delta-hedging is a way to express a view that future realized volatility will be higher than current implied volatility. Delta-hedging is not easy, however. You need systems, expertise, and time to measure your exposures and tradstock on a day-to-day basis. As well, it turns out that the p&l from trading volatility by delta-hedging doesnt only depend on what realized volatility turns out to be over the options life relative to the implied volatility at which the option is traded. Rather, it also depends on the exact path that the underlying takes. That is, delta-hedging p&l from two different price paths that result in identical annualized realized volatilities could be quite different depending on the specif-

ic paths over which the volatility is generated. These difficulties associated with delta-hedging long prevented many who would have liked to trade volatility from doing so. Variance swaps In the late 1990s, option dealers developed new products to help investors express views on whether future realized volatility will turn out to be higher or lower than volatilities being priced into options. The most common of these products is the Variance Swap. A variance swap is a simple product. On the trade date, a strike level of volatility is established, which, through the dealers hedge, is tied to levels at which implied volatilities are trading in the market. No payment is exchanged between parties on the trade date. When the variance swap expires, a single cash payment is exchanged between the party that is long and the party that is short. The payment equals a preset notional amount multiplied by the difference between the square of the actual realized volatility that has been observed during the life of the trade and the square of the strike level of volatility that was established on the trade date, i.e., Payment = Notional*[Realized Volatility 2 Strike Volatility 2]. If Realized Volatility is greater than Strike Volatility, then the party that is short pays the party that is long. If Realized Volatility is less than Strike Volatility, then the party that is long pays the party that is short. As noted previously, the Strike Volatility is linked to current levels of implied volatility through the dealers hedge. A dealer that buys (sells) a variance swap will typically hedge its exposure by buying (selling) a particular set of options on the trade date and delta-hedging that set of options on a close-to-close basis throughout the life of the trade. The set of options is designed such that the dealers delta-hedging p&l should closely replicate the p&l on the variance swap. In expressing views on future realized volatility versus current implied volatilities, the variance swap offers two main advantages over delta-hedging an option: 1) Simplicity there is no deltahedging to be done. 2) Purity the p&l only depends on actual realized variance versus the strike level of variance. Because of these advantages, the variance swap market has grown tremendously in recent years. Variance swaps on many broad-market indices, such as the S&P500, EURO STOXX 50, and Nikkei 225, have become commoditized. Terms of these OTC contracts have evolved and been standardized in such a way that you can largely eliminate your risk on an existing variance swap position established with one dealer via an offsetting trade with another. As well, there is a highlycompetitive market in variance swaps on single stocks1.

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Investors View | Carl Mason, Seth Weingram | Deutsche Bank

Other volatility trading methods and products Delta hedging an option through expiry or holding a variance swap to maturity allows an investor to speculate on whether future realized volatility will be higher or lower than current implied volatilities. There are also ways to express views on whether implied volatilities will rise or fall. Traditionally, investors have done so by trading combinations of listed options. Such methods tend to be involved, however, and p&l usually depends on other factors besides changes in implied volatilities. In recent years, dealers have introduced OTC products, including forward-starting options and forward-starting variance swaps, that allow investors to express such views more precisely and in simpler form. The growth of interest in volatility trading and the success of OTC variance swaps has also spurred the development of listed pure volatility products. The best known is the VIX Futures contract traded on the CBOEs Chicago Futures Exchange, which allows investors to express views on whether short-dated S&P 500 implied volatilities will rise or fall. More recently, the CBOE launched S&P 500 3-Month Variance Fu-tures, the first listed product to allow speculation as to whether future realized volatility will be higher or lower than current implied volatilities. To date, though, neither listed product has seen a great deal of institutional flow, likely because this class of investors already has access to highly-competitive markets in a variety of OTC volatilitytrading products. Specific volatility trading strategies Volatility traders use the techniques and products described above to express a wide variety of views. A sampling follows: Views on overall levels of volatility. Volatility tradin funds often take outright views on levels of volatility. Sometimes they are motivated by a belief that option-market expectations of future volatility are wrong, and sometimes they are motivated by a belief that imbalances in supply and demand for options have driven implied volatilities to levels where they no longer reflect consensus expectations of future realized volatility. Some funds switch from netlong to net-short volatility positions depending on market circumstances, as their view on whether the market is underestimating or overestimating future realized volatility
1 Terms of single-stock variance swaps typically differ somewhat from those described earlier.

changes. Some funds maintain a consistent long-volatility bias in the belief that the options market systematically underprices tail risk. Other funds look for structural features of the option market that they believe cause certain types of options to be chronically over-priced. As one noteworthy example of the latter, in 1997 and 1998 some hedge funds sold long-dated index options, taking the view that a prolonged short-squeeze in the market for long-dated index options had driven long-dated implied volatilities well above likely levels of future realized volatility. Relative value volatility trades. Volatility funds frequently take views that options on one stock or index are mispriced relative to one another, often based on fundamental criteria. Relative value volatility trades have become increasingly popular in recent months as market volatility has remained low. Many traders have become uncomfortable selling volatility outright, taking the view that there is little to gain and much to lose, but theyre also reluctant to buy volatility, having watched volatility remain subdued throughout the year. Views on the implied volatility term structure. Volatility traders speculate on the shape of implied volatility term structures, i.e., on whether short-dated implied volatilities on a given stock or index are too high or too low relative to longer-dated implied volatilities. Sometimes term structure trades are motivated by a view that the option market is mis-forecasting the volatility of an up-coming event, such as an earnings announcement. Views on the implied volatility skew structure. Volatility traders also speculate on relative levels of implied volatilities across strikes, i.e., across the implied volatility skew structure. Some skew trades are motivated by a belief that the market is misjudging the risk of a crash, in the case of an index, or a credit event, in the case of a single stock. Index dispersion trades. Dispersion trades are a particular form of relative value volatility trade in which the investor looks for mispricings of index options relative to options on the indexs component stocks. Such trades amount to expressing a view that the level of correlation being priced into an option on the index is too high or too low. Interest in dispersion trading has grown considerably in recent years.

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Investors View | Carl Mason, Seth Weingram | Deutsche Bank

Looking ahead: issues confronting volatility trading funds We conclude by highlighting two challenges facing volatility trading funds: 1) We think the volatility trading space shows some signs of overcrowding. Weve seen interest in volatility trading increase substantially in recent years, likely in part a function of capital inflows into hedge funds and a perception that opportunities offered by many other alternative investment strategies have diminished. As examples, weve seen many new volatility trading funds set up, and weve seen a number of convertible bond arbitrage funds add pure equity volatility positions to their books, a natural extension of their core strategies that involve a significant equity volatility component. Despite continued growth of investor demand for optionality (see Figure 3), we think increasing competition among volatility traders, dealers, proprietary trading desks, and hedge funds, has made it more difficult for volatility traders to make money. 2) The persistently low levels of realized volatility seen over the past 18 months have frustrated volatility traders (see Figure 1). The quiet environment has left many volatility traders searching for new opportunities, some shifting from taking speculative outright volatility positions to relative value volatility strategies, including volatility pair trades, long/short volatility basket trades, and dispersion trades. In light of these challenges, we think that volatility-trading hedge funds that act as liquidity providers have an edge. As alluded to previously, option dealers that do significant business with non-volatility-sensitive option investors are
Figure 3 | Notional of outstanding equity-linked derivatives (listed and OTC markets)
$3000 $2500 $2000 $1500 $1000

often happy to share profits with volatility trading hedge funds, because the hedge funds serve as a reservoir of liquidity to which the dealers can redistribute risk. As one example of this risk redistribution mechanism, this year option dealers have offered to buy correlation from hedge funds via new products called correlation swaps. These trades have benefited option dealers by allowing them to reduce unhedgeable correlation risk incurred through the sale of structured products to retail investors, and the volatility-arbitrage hedge fund community has benefited by being able to put on speculative correlation positions at attractive levels. In contrast, in an increasingly competitive environment, volatility trading funds that pursue strategies primarily based on perceived informational advantages, may find it increasingly difficult to find liquidity for their trades. In many cases, theyll look to take volatility views that option dealers would also like to take, and if they make money consistently, volatility traders will likely become increasingly suspicious of taking the other side of their transactions. To help alleviate this problem, volatility-trading hedge funds that are skilled at predicting future volatility may find that it pays to pursue strategies that have different risk characteristics than those typically taken by option dealers with whom they trade. For example, informationally-advantaged volatility traders might find it worthwhile to pursue strategies with both a volatility and directional component, so they can profit from their research while providing dealers with an incentive to trade. Derivative transactions involve numerous risks including, among others, market, counterparty default and illiquidity risk. The appropriateness or otherwise of these products for use by investors is dependent on the investors' own circumstances including their tax position, their regulatory environment and the nature of their other assets and liabilities and as such investors should take expert legal and financial advice before entering into any transaction similar to or inspired by the contents of this publication. Trading in options involves risk and is not suitable for all investors. Prior to buying or selling an option investors must review the Characteristics and Risks of Standardized Options, at www.option-sclearing.com/publications/risks/risks.jsp. If you are unable to access the website please contact Deutsche Bank AG (+1-212250-7994) for a copy of this important document. Member of SIPC. Securities in your account protected up to USD500,000. For details, please see www.sipc.org.

$500

$0

1998

1999

2000

2001

2002

2003

North America

Europe

Other

Source: DBSI estimates and calculations, Bank for International Settlements

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