VolatilityTrading: VolContracts™ Jump intothe Mix

To this day,vehicles to gain exposuretothe volatilityofanasset arefew and both limited in natureand in some cases,imperfect in design. The advent of exchange-traded VolContracts™, to be listed on The Exchange, will offer acompetitive alternative. changes Ex

52 Overview of Existing Products In these highly volatile times, traders, speculators, and hedgers Suppose, for example, that aspeculator or investor feltthat the alike might, upon occasion, wish to gain direct exposure to the Euro, whosecurrent three-month volatility is about 11%annualized, was going to become morevolatileover the coming three months. volatility itself of an underlying asset. While such adesire Such an investor might purchase athree-month volatility , with seems straightforward, in practice, it has not always been easy astarting, or reference,strike of, say,11.50 (percent).Anotional to obtain such exposure. This article explores three of the most value is established, such as $100,000 per volatility point,and the twocounterparties to thistypically over-the-counter transaction common manners by which traders currently gain exposure to agree to settle, in three months, according to the actual volatility the volatility of an underlying asset: Volatility and Variance that the Eurogoes on to display over the designated time period. Swaps, Delta-NeutralHedging of Options , and If, for example, Eurovolatility, as measured by the traditional VIX® Futures. We shall then discuss anew instrument, standard-deviation formula, turns out to be 13.50, the underlying’s volatility has surpassed the 11.50strike by two points, andthe hold- VolContracts™, to be traded on the soon-to-be-established er of the swap is entitled to 2 x $100,000,or$200,000 from Volatility Exchange. the issuer, upon settlement.Conversely, if the Euro exhibitsless volatility over the time period than the 11.50reference, say 9.00, TwoPrincipal Kinds of Volatility the swap holdermust remit (11.50–9.00) x $100,000, or $250,000, to the issuer. Before examining the products themselves, it behooves us to distinguish between the two main varieties of volatility that are commonly traded by the financial and investment communi- swap. These instruments are not really swaps, as there are not ties: realized volatility and . two different payouts that are being exchanged, or “swapped”. Realized volatility is defined as the annualized standard Rather, the investor simply receives from the provider the deviation of the continuously compounded returns of an asset. formula-derived volatility of aspecified underlying asset, over In essence, it is an expression, determined by amathematical adesignated time period, and with reference to abeginning formula, of the tendency of the underlying to display move- “”, or benchmark volatility. ment, regardless of direction. Traditionally, this movement is Although the volatility swaps’ concept is rather straightfor- measured by using close-to-close (interday) settlement prices, ward (see box), there are several drawbacks to using them. although it is entirely possible to capture intraday readings, as First, there is no access for retail traders, as, typically, swaps well. Realized volatility is often referred to as historical, or are traded on very large notional amounts. This restriction also asset, volatility. becomes problematic when one contemplates using avolatility By contrast, there is no straightforward formula for calcu- swap to trade on “all” assets. And, whereas such swaps might lating implied volatility.Wedon’t really calculate implied very well be suitable for investment banks and institutions, volatility as much as we observe volatility, or avolatil- they are considerably less so for market-makers looking to ity index, such as VIX, designed to represent the implied hedge volatility exposure, as swaps may be difficult to execute volatility of an array of options. Since avolatility estimate is quickly and at favorable prices with the sell-side counterparty. required as one of the inputs into the Black-Scholes option- Furthermore, there is no public quote for volatility or vari- pricing model (for options on stocks), the (for ance swaps, and, as such, they are subject to the credit risk of options on futures), or any other model, if, instead, we suppose the issuing agent and have neither transparency nor aready that the observable market price of the option is an input, we method for price discovery. Let us note in closing that variance “trick” the options model into furnishing the option volatility swaps, which reckon the square of volatility, or the variance of assumption that was used to price the option in the first place. the underlying asset, pose all of the same challenges as volatil- In essence, we obtain the option’s implied volatility by running ity swaps, with added volatility due to the exponential nature the option model “backwards”. of the variance calculation itself. So, the best answer to the question, “What is implied volatility?” is: the volatility that one would have to input into Delta-Neutral Options Hedging the options pricing model in order to arrive at the current In the listed markets, the time-honored approach for attempt- option price. ing to capture the realized volatility of an asset has been to buy or sell, via the use of options, an at-the-money (ATM) Volatilityand Variance Swaps (one call and one put) whose matches the period To date, there has been only one vehicle by which an investor over which one wishes to be exposed to the underlying’s may gain exposure to “pure” realized volatility, and that is the volatility, and then to manage the position with “follow-ups” volatility swap and its closely related counterpart, the variance designed to maintain “delta-neutrality”.

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53 As the traded options are transacted at acertain implied VIX Futures volatility, that value serves the same function as the strike So far, our discussions of volatility trading have centered upon price in our swaps discussion. In theory, as the options trader realized, or actual, asset volatility. The second variety of adjusts his or her “deltas”, or share exposure of the options, volatility, implied, is addressed by listed VIX futures and on, say, anightly basis, those trades are designed to “cap- options. ture” the actual volatility that the underlying asset is display- The Volatility Index, or VIX, for short, was created by the ing. This dynamic process is repeated throughout the holding Chicago Board Options Exchange (CBOE) and seeks to meas- period of the straddle and is driven by the very movement of ure aweighted average of the implied volatilities of awide the underlying that the hedging activity is designed to cap- range of options traded on the Standard &Poor’s 500 Index®. ture. If that volatility turns out to be greater than the implied This so-called “fear gauge” is often cited as abarometer for the volatility of the original transaction, the straddle buyer will aggregate sentiment of the investment community on future usually profit, while the seller would lose. Conversely, the directional movement not only of the volatility of the broad straddle seller, who is looking for lower volatility than what stock market, but also of the market itself, based on the strong he or she sold to establish the position, will hope that the sub- negative correlation between equity volatility and price move- sequent follow-up transactions will be sufficiently limited so ment. as to permit aprofit from an asset volatility that is lower than Futures contracts on the VIX trade on the Chicago Futures that sold to initiate the position. Exchange (CFE) and, therefore, enjoy some of the benefits of While straddle trading has several attractive features that transparency, exchange-trading, and price discovery that have OTC swaps do not, the former is not without considerable been mentioned above. Still there are some key problems with drawbacks of its own. Using options to capture an asset’s VIX. As VIX futures expire not to acalculated, or real, volatil- volatility will clearly appeal to market-makers and institution- ity, but rather to yet another forecast, or implied volatility, al clients, who will appreciate not only the transparency that traders can never be sure of capturing, via their VIX invest- comes with an exchange-traded vehicle (no credit risk), but ment, the actual volatility that the underlying displays. Instead, also the speed and relative ease with which the transaction the trader is obliged to speculate on what the sentiment of may be effected. In addition, such volatility trading can, in others will be, at the time of expiration, as to the future volatil- theory, be achieved for any asset on which listed options are ity of the underlying –avery tenuous , at best. What’s available. more, due to several complex pricing mechanisms, VIX futures But straddle trading is not without downsides. To start, themselves do not track well the underlying VIX Index, and the concept is complicated and requires knowledge of options several scholarly articles have documented these mistrackings sensitivities, such as delta, gamma, vega, etc. Retail traders of futures compared to the cash index. may not feel up to the task, and portfolio managers may shun Retail traders are often disappointed by the above phenom- amethod requiring constant monitoring and frequent trad- enon, as they do not always receive from the futures the same ing. Those who do engage in the practice are often frustrated change in volatility that the Index itself displays, while market- by the inconsistent marking policies of the options them- makers and institutions are hesitant to risk large amounts of selves, which may lead to annoyingly large swings in daily capital on what amounts to no more than afuture forecast of mark-to-market P&L. And, in illiquid markets with wide implied volatility. The arcane formula by which the actual VIX bid-offer options spreads, the transaction costs for follow- determination is achieved is off-putting to many, and critics ups, “rolling”, and overall position management can be quite have cautioned against the possibility of market manipulation, high. as the final settlement price of the futures is subject to aspecial Finally, the use of options straddles does not always achieve opening quote that depends, to acertain extent, on the liquid- what it sets out to do. There is a“path-dependency” compo- ity of the S&P 500 options. Yet, VIX futures provide the only nent to the process that often prevents the trader from actually current instrument for trading implied volatility. receiving the very volatility that he or she seeks. In essence, for the purpose of straddle trading, identical final volatility values VolContracts™ for the underlying, even if determined by the same formula, are In this environment, anew financial exchange is being not necessarily captured in equal fashion by the delta-neutral- launched comprising afutures and asecurities component. The hedging technique, and so, the method cannot always be relied Volatility Exchange will offer VolContracts™, futures-like upon to provide the “pure” volatility exposure that it purports instruments whose settlement will be based on the realized to capture. volatility of an underlying asset, instrument, or index.

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54 Available in various durations, they will expire to the actual Volatility & Delta- VIX® Features VolContracts™ Variance Neutral close-to-close volatility displayed by the asset, as calculated by (realized volatility) Futures (implied volatility) Swaps Hedging (realized volatility) (realized volatility) the Vol Formula, atraditional standard-deviation formula. Expires to actual, or X realized, X Path dependency does Calculating Realized Volatility volatility or ✓ Expires to a forecast ✓ not provide "pure" volatility exposure The formula to settle any VolContract™ on its expiration day variance X is the following: Appeals to X X retail traders Doesnot necessarily n ✓ react to changes in No access Too complicated 252 2 realized volatility Vol = 100• R Appeals to ? ? ¦ t Available on only a option market- May be difficult to n few equityindices, t=1 execute quickly and makers ✓ and not an effective ✓ at favorable prices For the first time, market participants will have access to a list- hedge Appeals to X ed realized-volatility product that can be traded on all assets, investment Not willing to risk banks and capitalon forecasting with the added benefits of low execution costs and ease of ✓ afutureforecast of ✓ ✓ institutions volatility calculation. Such an instrument is aimed at abroad range of Appeals to ? X portfolio X Losses can be extreme Requires constant investors, spanning from retail traders to investment banks and ✓ Not liquid enough managers for variance swaps monitoring institutions, and, especially, portfolio managers, as apowerful, Exchange- traded X (regulated with new risk-management tool. ✓ ✓✓Subject to credit risk no credit risk) Indeed, it has been demonstrated that an overlay of a Not subject ? 1 X Large swings in P&L volatility product, such as VolContracts™ ,toatraditional to market Special opening quote possibledue to ✓ that depends on ✓ manipulation inconsistent marking liquidity equity portfolio may substantially reduce the overall volatility policies of the holdings while having only avery slight negative impact Transparency and price X on actual returns. The result often can be an increased Sharpe discovery ✓ ✓✓No public quote ratio, avital measure of the risk-adjusted returns of aportfolio. Could be traded X ? on all assets ✓ Only on very liquid Must be traded ✓ VolContracts™ should be available on selected assets option markets in large size during the first half of 2011. The Volatility Exchange intends X X Easy to Formulais complex Calculationrequires to outsource its around-the-clock trading execution, clearing, calculate ✓ and cannot be ✓execution prices and verified without fee commissions for each compliance, and surveillance functions and to partner with paid for data feed transaction ? X Execution costs Market spreads and established marketplaces globally. No direct expense, but commissions on all low execution price may ✓ ✓legs and follow-up not be favorable trades Conclusion Several instruments exist that allow investors to gain exposure to, or to hedge, volatility. While swaps and options straddles capture realized volatility, the former are OTC instruments not Donald Schlesinger is currently the Vice Chairman readily available to the general public, while the latter do not and Chief Strategy Officer of The Volatility Exchange always reflect the actual volatility of the underlying. VIX Group. Before this he was an Executive Director in futures reflect asentiment and are intended to represent the Morgan Stanley Dean Witter’s Worldwide Equity aggregate implied volatility of S&P 500 options, but the Derivatives department. Some of his responsibilities at futures often mistrack the underlying cash, and some investors the firm included: Derivatives education and training, are left wanting when the futures expire to yet another forecast, establishing and perfecting risk-management tech- as opposed to aconcrete calculation. niques and systems for global equity derivatives, and VolContracts™ seem to respond well to all of the shortcom- managing the proprietary options book. ings of the above products and should offer an easily traded, Robert P. Krause is currently Chairman and Chief exchange-listed instrument that settles to realized volatility, Executive Officer of The Volatility Exchange Group. while appealing to awide array of market participants. He was also asenior member of staff at Event Capital 1 (http://econ.duke.edu/uploads/assets/dje/2008_Symp/Sloyer%20Tolkin.pdf) Markets, Zurich Capital Markets, Mitsui Com-

Trademarks: modities, Morgan Stanley, and the Chicago Mercan- VIX® is aregistered trademark of The Chicago Board Options Exchange Incorporated. S&P 500® is aregistered trademark of Standard &Poor’s Financial Services LLC. VolX® is aregistered trademark of The VolX Group tile Exchange. Corporation. VolContract™ is atrademark of Volatility Partners, LLC through exclusive license to The Volatility Exchange Corporation.

SWISS DERIVATIVES REVIEW 44 –AUTUMN 2010