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.