Equity derivatives traders are looking to make a market in variance options, which are being priced on a bespoke basis by several houses in Europe and the U.S. Hedge fund managers say Merrill Lynch, Banc of America Securities and Citigroup have all traded options on volatility and several other houses, including Deutsche Bank and Société Générale, are reportedly close to executing trades. Variance is the square of volatility. Traders in banks, however, are concerned the market could be limited if hedge funds are only interested in buying options.
Michael Weber, principal of Eriswell Capital in London, believes there is potential for a two-way market. Funds will be interested in selling the instruments for the premium, he said. "This is a great initiative," said Weber, who bought a two-month put option on the volatility of the Euro STOXX50 in August. Gerry Fowler, in derivatives research at Citigroup in London, said, "The market is growing very quickly." Citi has traded options on Euro STOXX volatility with some major clients, but Fowler added, "There's definitely space to use other indices."
The fact that the options being traded are on variance means they have a payoff that is nonlinear to volatility. Traders said this makes the instrument particularly appealing to hedge funds taking a view on volatility, because there is potential for a big payoff if their bet is right. Banc of America Securities, however, is understood to be offering some clients options on volatility.
