Volatility Trading - Hedge Fund Strategies

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

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Volatility Trading - Hedge Fund Strategies

  1. 1. Hedge Fund Strategies Volatility trading
  2. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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.

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