Money managers looking to arbitrage volatility dislocations should short front-month VIX futures via deep in-the-money puts to cash in on the negative performance of long VIX futures rolls put on by other institutions in the market, said Krag Gregory, equity derivatives strategist at Goldman Sachs in a presentation at the Chicago Board Options Exchange Risk Management Conference in Bonita Springs, Fla., this morning.
Gregory pointed out that several current factors point to a vol dislocation that can be taken advantage of by going short volatility. First, realized volatility is at 8% over the first two months of the year while its average has been approximately 15% over the last century. Additionally, the VIX, tracking implied volatility, has mistracked realized volatility by a few volatility points each year over the last 20 years, and just a week ago was just under 20% for one-month variance swaps. While many market participants assume a sub-20% VIX level means the market has become complacent and is primed for a spike, said Gregory, in fact the spread between realized and implied is still 10% and thus represents an opportunity for short vol plays.
In terms of implementation, Gregory pointed to short variance swaps but also rolling short front-month VIX futures. Generally, market participants hedge large market events by going long VIX futures and rolling them into the next contract at the end of each trade. At least partially as a result of that phenomenon, rolling those futures is expensive. In Gregory’s estimation, shorting the one-month VIX future and rolling the contract one business day before the end of the contract would have provided a cumulative profit of 8.25% in volatility terms over the first two months of 2012. Short variance swaps would have provided USD7.7 for every USD1 vega notional invested over the same term.
Perhaps most interestingly, Gregory found that a 30% in-the-money forward option would have provided 19.72% of profit versus a negative 3.93% performance of a 10% out-of-the-money option from April of 2006 until last week. Since Dec. 30, 2011, the same trades presented a disparity of 6.89% over 1.36%.
Short volatility trades have been on the mind of market participants, especially in the U.S. and since the summer of 2011 when unpredictable markets hurt many traders. Salesmen told DI before the New Year that traders had been looking to short volatility, but wanted to wait for a market calm. The normalization of U.S. equity markets over the first two months of 2011 has re-sparked the debate as to how to trade volatility.
