Two new products hope to make volatility trading a no-brainer.
All derivatives traders know that option prices really boil down to the market’s expectation of the future volatility of the underlying instrument, because all the other determinants of an option’s price—the underlying price, time to maturity, interest rate and strike price—are objective. Volatility is the X factor, and only rarely does an option’s actual, realized volatility replicate the implied volatility reflected in its valuation.
Traders typically hedge implied volatility by constructing elaborate—and often highly expensive—series of short and long straddles based on differing strike prices, styles and expirations. Although over-the-counter volatility structures have been offered for years, they have been highly illiquid and do not offer price transparency—characteristics sure to scare off traders.
Now volatility traders will have a much easier time of it, thanks to two new products released in January: volatility futures from the Deutsche Terminborse and volatility swaps from Salomon Smith Barney.
The DTB became the first exchange in the world to list volatility futures based on an underlying index of implied volatility when it launched the VOLAX future on January 19. The VOLAX is based on the implied volatility of its DAX index options, which is represented by the VDAX, a set of eight volatility indices introduced by the DTB last summer.
VOLAX futures allow traders of DAX options the ability to manage their volatility risk in a single instrument. “There are certain traders in the market who play with volatilities to trade volatility strategies,” says Elmar Werner, product developer at the DTB. “It is much easier for them to use the VOLAX instead of a combination of DAX options. It’s cheaper in terms of the exchange fees, and you don’t have to look for the combinations. It’s a single product that’s more efficient and easier to use.”
VOLAX futures have a number of other uses as well, including hedging warrant issues; eliminating the vega component (the change in an option’s price caused by changes in volatility) upon the creation of delta (the degree of change in an option’s premium, based on changes in the underlying) or gamma (the rate of change of delta) positions; and facilitating the buying or selling of options upon extremely high or low volatilities for DAX option market makers who are obliged to make binding quotes. The instruments can also be used to speculate on rising or falling volatilities, to exploit mispricings across the DAX option volatility curve, to arbitrage against DAX options, and to serve as the underlying for warrants. (See box.)
But what about traders who aren’t exposed to the DAX but want to hedge their volatility risk? Salomon Smith Barney thinks it has the answer for them. In January the firm began promoting volatility swaps, a product meant to appeal to traders who want to hedge their volatility exposures without constructing elaborate and unwieldy positions—and who thus want to escape bid-offer spreads, commissions, clearing costs and the various trade-support costs that the listed markets reap.
Volatility swaps are traded as follows: Salomon Smith Barney enters into an OTC agreement with a counterparty. At maturity, the value of the swap depends only on the realized volatility of the asset, and not the volatility path the asset has taken during the life of the trade, which can sometimes make for higher costs in traditional listed volatility structures. The investor merely contracts with Salomon Smith Barney, which either buys or sells an option portfolio, delta hedges the portfolio and pays the customers the positive return or collects the negative return. Salomon takes care of all the operational costs, including risk management, systems, traders, back office and clearing.
Volatility swaps have several applications. Customers can sell swaps on the one-year volatility of the Standard & Poor’s 500, an attractive proposition for those who don’t expect the market to crash in the next 12 months. The S&P one-year volatility is currently trading around 25 percent, even though realized one-year volatility has rarely exceeded 18 percent, largely as a result of investor nervousness. Corporates can short individual stock volatility to hedge their volatility exposures when planning to issue convertible bonds. According to Salomon, “if volatility were to decline, the higher coupon the company would have to pay would be offset by the positive value of the swap at maturity…[while] if the volatility were to increase, the convertible to be issued would be more valuable…[so] the company could pay a lower coupon.”
Many funds have positions in Japanese converts and warrants, leaving them long volatility of individual stocks. Since there are no listed option markets in Japan for equities, shorting some stocks can be difficult. Salomon’s new swap products allow investors to hedge their long volatility positions in Japanese equities by selling one-year or even two-year Nikkei volatility to Salomon. In addition, index funds can use Salomon volatility swaps to reduce the amount of tracking error that could attend massive increases in market volatility.
Some have predicted that volatility will become the next big asset class. Salomon and DTB certainly hope that’s the case more rather than less, sooner rather than later.
Arbing the VOLAX
The VOLAX could present tremendous arbitrage profit possibilities if it is mis-priced early on. According to the DTB, by constructing a “replication portfolio” of the VOLAX, traders can arbitrage overvalued VOLAX futures relatively easily. For example, say the fair price of the VOLAX is DM 1,575, but the VOLAX is traded at DM 1,600—an arbitrage window of DM 25. To arbitrage 100 VOLAX futures, a replication portfolio consisting of 102 long straddles expiring at Tl and 80 short straddles expiring at Ts is constructed, paid for by borrowing from the money market. The delta of the replication portfolio is 19.72, far below that of a DAX future. At Tl, the VOLAX is no longer mispriced, so the arbitrage window closes. The forward volatility at Tl has risen to 16.25 percent, and the DAX has fallen by 50 points, so the VOLAX is now traded at DM 1625. Buying back 100 VOLAX futures therefore results in a loss of DM 2,500, but this is divided into the loss resulting from the change in fair futures price, which is DM 5,000. The result: a profit of DM 2,500.
—Source: Deutsche Terminborse
Prepackaged Volatility Plays
All derivatives traders know that option prices really boil down to the market’s expectation of the future volatility of the underlying instrument, because all the other determinants of an option’s price—the underlying price, time to maturity, interest rate and strike price—are objective. Volatility is the X factor, and only rarely does an option’s actual, realized volatility replicate the implied volatility reflected in its valuation.
Traders typically hedge implied volatility by constructing elaborate—and often highly expensive—series of short and long straddles based on differing strike prices, styles and expirations. Although over-the-counter volatility structures have been offered for years, they have been highly illiquid and do not offer price transparency—characteristics sure to scare off traders.
Now volatility traders will have a much easier time of it, thanks to two new products released in January: volatility futures from the Deutsche Terminborse and volatility swaps from Salomon Smith Barney.
The DTB became the first exchange in the world to list volatility futures based on an underlying index of implied volatility when it launched the VOLAX future on January 19. The VOLAX is based on the implied volatility of its DAX index options, which is represented by the VDAX, a set of eight volatility indices introduced by the DTB last summer.
VOLAX futures allow traders of DAX options the ability to manage their volatility risk in a single instrument. “There are certain traders in the market who play with volatilities to trade volatility strategies,” says Elmar Werner, product developer at the DTB. “It is much easier for them to use the VOLAX instead of a combination of DAX options. It’s cheaper in terms of the exchange fees, and you don’t have to look for the combinations. It’s a single product that’s more efficient and easier to use.”
VOLAX futures have a number of other uses as well, including hedging warrant issues; eliminating the vega component (the change in an option’s price caused by changes in volatility) upon the creation of delta (the degree of change in an option’s premium, based on changes in the underlying) or gamma (the rate of change of delta) positions; and facilitating the buying or selling of options upon extremely high or low volatilities for DAX option market makers who are obliged to make binding quotes. The instruments can also be used to speculate on rising or falling volatilities, to exploit mispricings across the DAX option volatility curve, to arbitrage against DAX options, and to serve as the underlying for warrants. (See box.)
But what about traders who aren’t exposed to the DAX but want to hedge their volatility risk? Salomon Smith Barney thinks it has the answer for them. In January the firm began promoting volatility swaps, a product meant to appeal to traders who want to hedge their volatility exposures without constructing elaborate and unwieldy positions—and who thus want to escape bid-offer spreads, commissions, clearing costs and the various trade-support costs that the listed markets reap.
Volatility swaps are traded as follows: Salomon Smith Barney enters into an OTC agreement with a counterparty. At maturity, the value of the swap depends only on the realized volatility of the asset, and not the volatility path the asset has taken during the life of the trade, which can sometimes make for higher costs in traditional listed volatility structures. The investor merely contracts with Salomon Smith Barney, which either buys or sells an option portfolio, delta hedges the portfolio and pays the customers the positive return or collects the negative return. Salomon takes care of all the operational costs, including risk management, systems, traders, back office and clearing.
Volatility swaps have several applications. Customers can sell swaps on the one-year volatility of the Standard & Poor’s 500, an attractive proposition for those who don’t expect the market to crash in the next 12 months. The S&P one-year volatility is currently trading around 25 percent, even though realized one-year volatility has rarely exceeded 18 percent, largely as a result of investor nervousness. Corporates can short individual stock volatility to hedge their volatility exposures when planning to issue convertible bonds. According to Salomon, “if volatility were to decline, the higher coupon the company would have to pay would be offset by the positive value of the swap at maturity…[while] if the volatility were to increase, the convertible to be issued would be more valuable…[so] the company could pay a lower coupon.”
Many funds have positions in Japanese converts and warrants, leaving them long volatility of individual stocks. Since there are no listed option markets in Japan for equities, shorting some stocks can be difficult. Salomon’s new swap products allow investors to hedge their long volatility positions in Japanese equities by selling one-year or even two-year Nikkei volatility to Salomon. In addition, index funds can use Salomon volatility swaps to reduce the amount of tracking error that could attend massive increases in market volatility.
Some have predicted that volatility will become the next big asset class. Salomon and DTB certainly hope that’s the case more rather than less, sooner rather than later.
Arbing the VOLAX
The VOLAX could present tremendous arbitrage profit possibilities if it is mis-priced early on. According to the DTB, by constructing a “replication portfolio” of the VOLAX, traders can arbitrage overvalued VOLAX futures relatively easily. For example, say the fair price of the VOLAX is DM 1,575, but the VOLAX is traded at DM 1,600—an arbitrage window of DM 25. To arbitrage 100 VOLAX futures, a replication portfolio consisting of 102 long straddles expiring at Tl and 80 short straddles expiring at Ts is constructed, paid for by borrowing from the money market. The delta of the replication portfolio is 19.72, far below that of a DAX future. At Tl, the VOLAX is no longer mispriced, so the arbitrage window closes. The forward volatility at Tl has risen to 16.25 percent, and the DAX has fallen by 50 points, so the VOLAX is now traded at DM 1625. Buying back 100 VOLAX futures therefore results in a loss of DM 2,500, but this is divided into the loss resulting from the change in fair futures price, which is DM 5,000. The result: a profit of DM 2,500.
—Source: Deutsche Terminborse
Prepackaged Volatility Plays
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