Considerations in volatility trading
By Scott Maidel, senior portfolio manager at Russell Investments
What Is Volatility?
“Volatility” can mean different things. Portfolio volatility (and variance) may be discussed in three different contexts:
1. Realised volatility–historical volatility, as observed over a specific period;
2. Implied volatility–typically, the volatility that is implied in option prices;
3. Expected volatility–an expectation of, or a forecast for, volatility over a specified future period.
The often cited volatility risk premium is typically discussed as a difference between an asset’s implied/expected and its realised volatility. Volatility traders often concentrate on:
• Implied to realised volatility – which refers to spread, in annualized volatility points, between option-implied volatility and the subsequent realised volatility of the underlying;
• Volatility skew — systematic changes in implied volatility due to changes in option strike value (for example, the higher implied volatility typically associated with both lower strikes on equity index options and higher strikes on volatility options);
• Volatility term structure — the level of volatility across tenor (time to expiration) for a specific option type or futures curve;
• Volatility of implied volatility — this refers to the option-implied volatility of volatility options.
After this look at how market participants discuss and approach volatility, our next logical questions are: Why does a volatility risk premium exist and persist? Is volatility an asset class, and what are my alternatives for managing portfolio volatility? Lastly, we touch on strategy construction techniques for harvesting the volatility premium.
For the remainder of this article, we will be communicating from the perspective of a volatility-selling program on broad-based equity indexes and volatility indices. Short index volatility strategies have the potential to achieve passively generated returns, an appealing diversification and risk-adjusted return benefit.
Why does a volatility risk premium exist and persist?
Historically, implied volatility exceeds its ex-post realised volatility more than 80% of the time, meaning that option buyers typically pay too much. In general, investors are risk-averse, and they will pay more than is “fair” for the insurance that an option (or a volatility exposure) provides by buying the downside economic risk. There is a similar dynamic in the matter of why insurance companies are profitable: they receive more in insurance premiums than they are required to pay in claims. A diversified portfolio of volatility strategies may provide a similar economic gain over the long term.
The most commonly referenced implied volatility measure is the CBOE S&P 500 Implied Volatility Index (VIX). Exhibit 1 displays the VIX in relation to the S&P 500 Index. Exhibit 2 displays the implied volatility to realised volatility spread, in annualized volatility points, of the VIX versus the subsequent realised volatility of the S&P 500. This spread has persisted over various market and volatility environments and has exceeded subsequent annualized realised volatility by 28%, on average, since 1990, and 31% since March 2009.
Is volatility an asset class?
There is no consensus on this question. And quite honestly, it doesn’t matter. The same discussion can be had of the broad hedge fund universe or the securitization of insurance-type investments. Exposure to volatility (or variance) is expected to generate future payoffs with particular features. The issue is whether investors will benefit from adding such exposure to their portfolios. The important starting point is to acknowledge that buying volatility is a hedging activity and that selling volatility, whether in equity, commodity, rates or FX, is a risk-seeking facilitation of hedging flow that demands compensation. Whether the investor allocates the exposure among equity, alternatives or other investments is left to individual or plan preference.
All this said, there is good reason to think of volatility as being a new asset class. VIX-style volatility options and futures are now available for the Vstoxx and the Russell 2000 Volatility Index; for gold and oil; and for some individual securities. One volatility trading framework enables investors to understand and trade all these instruments, even though the underlying assets can be from different asset classes. We believe investors should think twice before closing the door on this opportunity.
What are alternative portfolio management techniques?
While there is conceptual overlap among the different approaches to managing risk, it is important to make the distinction between managing overall portfolio volatility with traditional portfolio techniques versus entering into a specific volatility trading strategy.
The landscape for managing volatility includes:
• Strategically de-risking — holding less-risky assets;
• Diversifying — among additional asset classes;
• Changing the driver of return sources — pure volatility risk-premium strategies;
• Changing the shape of the return distribution — covered call, put write, equity replacement strategies;
• Changing the exposure based on risk regime — volatility-responsive asset allocation.
Strategy construction techniques for harvesting volatility premium
A few of the most common examples of return-seeking short volatility strategies are covered calls; cash-secured put writes; short delta-hedged index options; short equity index variance swaps; and short VIX futures. Some volatility strategies include embedded market beta (directional) exposure, while some can be considered pure exposures to volatility. Covered call and put-write strategies are examples of those with embedded directional exposure. Whether investors are utilising options, swaps or futures, common to the use of any of these instruments is the need to specify trading strategy.
If a strategy is implemented systematically, its construction can define:
• Tenor selection — such as weekly, biweekly and monthly options or swaps, and front- or back-month futures. Under normal circumstances, for a volatility selling strategy, shorter tenor instruments should be considered, due to the speed of time decay for options or the magnitude of the term structure roll-down, which is typically highest for closest-to-maturity instruments.
• Strike selection (if applicable) — such as a predefined strike based on option moneyness, or delta. This selection depends greatly on the trader’s skill and experience, but a general assumption is that out-of-the-money options typically have the largest gap between implied and subsequent realised volatility.
• Roll diversification — by overlapping the maturity cycle, which has an overall smoothing effect on strategy risk profile. This strategy is operationally more complex, but it may reduce investment risk.
For those seeking to achieve long-term favorable results, careful implementation of volatility strategies is critical.
Operational considerations cannot be overlooked. They can include:
• Frequency of settlement requirements;
• Availability of listed option strike and tenor versus OTC (specific to options);
• Margin requirements for listed instruments versus OTC;
• Reporting requirements.
The volatility strategies described here are systematically net short over long term rolling horizons. From the perspective of a short volatility strategy, we believe in diversifying across multiple sources of structural volatility risk premia. Taken together, the results offer a compelling reason for adding volatility strategies to a diversified portfolio. Diversifying among strategies seeks to balance return potential with overall portfolio standard deviation, risk adjusted return and diversification benefits.