Download - Volatility Trading - Hedge Fund Strategies
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Hedge Fund Strategies
Volatility trading
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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
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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?
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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
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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?
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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
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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
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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
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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
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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
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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
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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
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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