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Volatility Trading - Hedge Fund Strategies

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A brief overview of a hedge fund strategy used in alternative investment markets.

A brief overview of a hedge fund strategy used in alternative investment markets.

Published in: Business, Economy & Finance

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  • 1. Hedge Fund Strategies Volatility trading
  • 2. Volatility trading Index: 1. What is volatility? 1.1. Implied Volatility versus Realized Volatility 2. Why is it so important for options trading? 3. Distributional Properties of Volatility 3.1. Volatility Mean Reversion 3.2. Volatility Smile/Skew 3.3. Term Structure of Volatility 4. Volatility Strategies in Practice 4.1. Volatility dispersion or dispersion trading 4.2. Volatility spread 4.3. Gamma trading strategy 5. References
  • 3. 1. What is volatility? 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)
  • 4. 1. What is volatility? 1.1. Implied Volatility versus Realized Volatility 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)
  • 5. 2. Why is it so important for options trading? 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.
  • 6. 3. Distributional Properties of Volatility 3.1. Volatility Mean Reversion Volatility tend to return to their historical averages – being mean reverting, over the long term. (Marshall 2008)
  • 7. 3. Distributional Properties of Volatility 3.2. Volatility Smile/Skew 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-themoney (ITM) calls and puts and for. The graph: “smiling face”
  • 8. 3. Distributional Properties of Volatility 3.3. Term Structure of Volatility 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.
  • 9. 3.3. Term Structure of Volatility 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)
  • 10. 4. Volatility Strategies in Practice 4.1. Volatility dispersion or dispersion trading 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)
  • 11. 4.2. Volatility spread 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)
  • 12. 4.3. Gamma trading strategy 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)
  • 13. 5. References Klein, H., 2006, ‘Volatility Trading’, in Eureka Hedge, viewed 2 August 2013, from http://www.eurekahedge.com/news/16_june_Davinci_Vola tility_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.