TRADING VOLATILITY AS AN ASSET CLASS

Emanuel Derman Columbia University

emanuel@ederman.com www.ederman.com

Page 1 of 37 June 10, 2003

Summary
Volatility is a useful trading hedge against all kinds of disasters. How can you trade it? Calls and puts don’t quite do it. Though calls and puts are sensitive to volatility, they are not sensitive only to volatility. How can you do better? 1. WHY TRADE VOLATILITY? 2. VOLATILITY TRADING WITH OPTIONS: THE VALUE OF CURVATURE 3. OPTIONS TRADING: WHAT CAN GO WRONG 4. THE VOLATILITY SMILE VIOLATES BLACK-SCHOLES 5. WHAT CAUSES THE SMILE? 6. IS THE SMILE FAIR? 7. TRADING & PRICING VOLATILITY USING VOLATILITY SWAPS
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I

I WHY TRADE VOLATILITY?

WHY TRADE VOLATILITY?

Volatility is the simplest measure of a stock’s riskiness or uncertainty. Different types: realized volatility, implied volatility, local volatility...

Page 3 of 37 June 10, 2003

interest rates. commodities.Realized Volatility The realized daily volatility σd of an equity index Si over a period of N days is the square root of the variance of the daily returns ri: ∆S i r i ≈ -------Si σd 2 1 = --N ∑ i 2 1 ( r i ) –  --N ∑ i 2 r i  I WHY TRADE VOLATILITY? Stock returns are roughly random and normal. ∆S ≈ σS ∆t σ annual ∼ 16 × σ daily Similarly for currencies. volatility itself. 2003 . variance grows ~ return time. Page 4 of 37 June 10.

I WHY TRADE VOLATILITY? Implied volatility Σ is the value of the volatility σ you have to insert into the Black-Scholes formula to make it match the market price of an option.Implied Volatility Black-Scholes: the fair price of a stock option depends on its future realized volatility. C BS = C ( S. 2003 . t. K. T. σ ) Black-Scholes is both a model and a quoting mechanism for options prices. plus a spread. r. You can think of it as the market’s expectation of future realized volatility. Page 5 of 37 June 10.

It’s the implied yield based on price. Forward rates: the future realized rates. that must come to pass to make current yields of all liquid bonds fair. based on Black-Scholes.Bonds and Options /Yields and Volatilities Bonds Interest rates are the parameters people use to quote bond prices. moment by moment. that must come to pass to make current implied volatilities fair. 2003 . Options Volatilities are the parameters people use to quote options prices Realized daily volatility: the actual volatility of an index Implied volatility of an option: the average of future realized volatilities that make the options price fair. Page 6 of 37 June 10. index level by index level and moment by moment. I WHY TRADE VOLATILITY? Realized daily interest rates: actual short-term interest rates Yield to maturity of a bond: the average of the future realized rates that make that bond price fair. Local (forward) volatilities: the future realized index volatilities.

. • Trading the spread between realized and implied volatility levels. They often take short positions in the spread between stocks of companies planning to merge. • It goes up and tends to stay up when most assets go down.. Index vs. If overall market volatility increases. stock. • Hedging implicit volatility exposure. short-term vs. domestic.Why Trade Volatility? Attractive characteristics: • It grows when uncertainty increases. currencies. assuming that the spread will narrow if the merger takes place. longterm.. You need views about future uncertainty to trade it. I WHY TRADE VOLATILITY? Page 7 of 37 June 10. Types of volatility trading: • Speculative trading of volatility levels in various markets. and the spread may widen. foreign vs. • It reverts to the mean. Hedge funds and risk arbitrageurs are often implicitly short volatility. these mergers are less likely to occur. 2003 . rates.

II II VOLATILITY TRADING WITH OPTIONS VOLATILITY TRADING WITH OPTIONS Page 8 of 37 June 10. 2003 .

• As an investor. lose if it goes down. how do you profit no matter whether the index goes up or down? Page 9 of 37 June 10. • You have a linear position in ∆S over the next instant ∆t.A Linear Security: A stock or index ASSUMED STOCK EVOLUTION: P&L OF A STOCK POSITION: P&L = ∆S S ∆S S0 II VOLATILITY TRADING WITH OPTIONS ∆S ∆t • If you own a stock or index. you make money if it goes up. 2003 .

A Curved Security To make money irrespective of direction. C S = = curved hedge long call Page 10 of 37 June 10. 2003 short stock . you want a security which gives you a curved P&L: a quadratic position in (∆S)2: P&L = (1/2)Γ(∆S)2 curvature Γ II VOLATILITY TRADING WITH OPTIONS ∆S To get curvature: delta-hedge away the linear part of a call option.

with magnitude depending on option’s curvature Γ and stock price S2 Page 11 of 37 June 10. 2003 .loss ~(1/2)Γ[σ 2 -Σ2]S2 ∆t index shift ∆S A hedged position makes money if realized vol exceeds implied vol.P&L of Delta-Hedged Options gain ~ 1/2Γσ 2S2∆t The gain due to a move ∆S with realized vol σ index shift ∆S loss ~ (1/2)Σ2S2∆t II VOLATILITY TRADING WITH OPTIONS The loss in an instant ∆t if expected vol is Σ gain .

P&L Depends on Realized Vol vs.∫ Γ S  σ – Σ  ∆t   2 Long options: you make money if σ > Σ Short options: you make money if σ < Σ II VOLATILITY TRADING WITH OPTIONS Page 12 of 37 June 10. Implied Vol 2 2 2 1 Net P&L = -. 2003 .

III III OPTIONS TRADING: WHAT CAN GO WRONG OPTIONS TRADING: WHAT CAN GO WRONG Page 13 of 37 June 10. 2003 .

1. It’s Not A Clean Bet on Volatility Alone 2 2 2 1 Net P&L = -. you get very little bang for your option buck. 2003 . Page 14 of 37 June 10. The Γ (Gamma) (Curvature) of an option as stock price S varies sharply: III OPTIONS TRADING: WHAT CAN GO WRONG 100 call If the stock price moves away.∫ Γ S  σ – Σ  ∆t   2 2 Γ S is irritating.

Page 15 of 37 June 10. Real markets violate Black-Scholes assumptions because of: • Jumps. 2003 . a known future volatility. • You cannot really hedge continuously. Delta-Hedging In Practice Is Risky Delta-hedging assumes smooth stock movements.2. you must hedge discretely. • Stochastic volatility: the future realized volatility which determines your hedge ratio is not known. • Transaction costs. Let’s look at just one example -.discrete hedging. III OPTIONS TRADING: WHAT CAN GO WRONG All of these imperfections may overwhelm any theoretical gain. no transactions costs. continuous hedging.

512 dollars.41 About 16% error.5 III OPTIONS TRADING: WHAT CAN GO WRONG N=21 (roughly daily) Mean=0 Standard deviation=0.5 -1 -0.5 24 20 16 12 8 4 -1. But that introduces large transactions costs and shifts the expected return. hedge N times for 1-month ATM put with 20% realized vol. Page 16 of 37 June 10.Example: Error When Hedging is Discrete Perfect Black-Scholes world. 2 vol pts Your P&L isn’t guaranteed unless you hedge continuously. The Black-Scholes value is 2. It’s not easy to make money this way.5 1 Final profit/loss 1.5 0 0. Monte Carlo simulation of the P&L: 28 28 Frequency (out of 100%) Frequency (out of 100%) 24 20 16 12 8 4 -1.5 0 0.5 -1 -0. 4 vol pts N=84 Mean=0 Standard deviation=0. 2003 .5 1 Final profit/loss 1.20 About 8% error.

IV IV THE VOLATILITY SMILE VIOLATES BLACK-SCHOLES THE VOLATILITY SMILE VIOLATES BLACK-SCHOLES The “smile” is the characteristic variation of implied volatility with strike and expiration. 2003 . Page 17 of 37 June 10. It is inconsistent with the Black-Scholes model everyone uses.

Page 18 of 37 June 10. not just in practice. IV THE VOLATILITY SMILE VIOLATES BLACK-SCHOLES Black-Scholes is wrong in principle. all options would have the same implied volatility. • It is the future volatility the index must have to make the BlackScholes price fair. • If the Black-Scholes model is correct. and therefore hedging is even more difficult. 2003 .Implied Volatility Σ Violates Black-Scholes • Implied volatility is the single value of the volatility you have to insert into the Black-Scholes model to match the market price of an option. • That isn’t the case.

“Implied Binomial Trees” J. (a) Pre-crash.95 0. of Finance. 20 IV THE VOLATILITY SMILE VIOLATES BLACK-SCHOLES V olatility 18 16 14 0.and Post-Crash Implied Volatilities: Since the ‘87 crash there has been a persistent skewed structure in Black-Scholes implied volatilities in most world equity option markets. Data taken from M. Rubinstein.Pre.975 1 1. 69 (1994) pp 771-818.025 1. Representative implied volatility skews of S&P 500 options. (b) Post-crash. 2003 .95 0.05 Strike/Index Page 19 of 37 June 10.975 1 1.05 Strike/Index (b) 20 V olatility 18 16 14 0.025 1.

2003 . Global Three-Month Volatility Skews Mar 99 IV THE VOLATILITY SMILE VIOLATES BLACK-SCHOLES 50 45 40 35 30 25 20 25D Put Atm 25D Call Nikkei 225 S&P 500 g Hang Sendg FTSE 100 DAX CAC 40 MIB 30 SMI AEX Σ ( K ) = Σ atm – b ( K – S 0 ) Page 20 of 37 June 10. almost linear.A Persistent Negative Global Skew/Smile A persistent large skew. and inconsistent with BlackScholes.

Page 21 of 37 June 10. 2003 . IV THE VOLATILITY SMILE VIOLATES BLACK-SCHOLES • Out-of-the-money puts always have higher implied volatilities than out-of-the-money calls.The Implied Volatility Surface of Indexes The implied volatility surface for S&P 500 index options as a function of strike level and term to expiration on September 27. 1995. • Short-term volatilities are usually more volatile. • Implied volatility is usually greater than recent historical volatility.

per 1% change in strike 1 Mon 3 Mon 6 Mon 12 Mon IV THE VOLATILITY SMILE VIOLATES BLACK-SCHOLES Single stock smile VOD Imp Vol (12/27/01) 70% 60% Imp Vol 50% 40% 30% 0.5 1 Mon 3 Mon 6 Mon 12 Mon Page 22 of 37 June 10. 2003 .25 1.More recent S&P 500 smiles SPX Imp Vol (12/26/01) 70% 60% Imp Vol 50% 40% 30% 20% 10% 0% 0.25 1.5 slope ~ 1 vol pt.75 1 Strike/Spot 1.75 1 Strike/Spot 1.5 0.5 0.

85 123.Some currency smiles.. 2003 ..67 I Page 23 of 37 June 10.90 9.. USD/EUR MXN/USD JPY/USD IV THE VOLATILITY SMILE VIOLATES BLACK-SCHOLESATM Strike = 0.

You own a specific strike vol.ATM vol isn’t something you own. 2003 11-02-98 . Page 24 of 37 June 10.Negative Correlation Between Implied Vols and Index Levels Three-Month Implied Volatilities of SPX Options 65 60 55 50 45 40 35 30 25 20 15 1200 1150 1100 1050 1000 950 900 850 800 750 700 650 IV THE VOLATILITY SMILE VIOLATES BLACK-SCHOLES INDEX ATM 09-01-97 10-01-97 11-03-97 12-01-97 01-02-98 02-02-98 03-02-98 04-01-98 05-01-98 06-01-98 07-01-98 08-03-98 09-01-98 10-01-98 But be careful .

are movements of the entire surface. and 5% related to out-of-the-money short term puts. • Few modes explain most of the variation. 2003 .Patterns of Change in the Volatility Surface Volatility surfaces fluctuate in modes: ∆Σ = β 1 ( volatility level mode ) + β 2 ( term structure mode ) + β 3 ( skew mode ) + other modes : Modes. and “twists. One finds about 85% of moves are parallel.” Modes are useful when: • They can be understood intuitively. Page 25 of 37 June 10. IV THE VOLATILITY SMILE VIOLATES BLACK-SCHOLES As with interest rates. there are parallel shifts. 10% changes in slope with respect to time. • Modes are historically stable. or factors. “steepening”.

V V WHAT CAUSES THE SMILE? WHAT CAUSES THE SMILE? Page 26 of 37 June 10. 2003 .

2003 V WHAT CAUSES THE SMILE? .purchases of collars • Expectation of changes in volatility • Fear of crashes (down for equities.Causes of The Smile Behavioral causes: • Supply and demand . up for gold After a crash. Page 27 of 37 June 10.and time-dependent effects resistance levels in stocks support levels in currencies change of volatility behavior at low interest rates Also: • Fat tails in distributions • Leverage effects • Transactions costs? • Uncertain future volatility All of these effects make Black-Scholes wrong: the underlier doesn’t carry out simple Brownian motion. realized and implied volatilities will be higher correlation of individual stocks in a jump down increases • Level.

Models for the Smile Classic Black-Scholes: constant volatility V WHAT CAUSES THE SMILE? Local volatility models: correlated volatility Stochastic volatility models: Jump-diffusion models: small probability of a large jump random volatility jump S diffuse Page 28 of 37 June 10. 2003 .

• Currencies tend to have stochastic volatilities. • Stock markets tend to jump in the short run. V WHAT CAUSES THE SMILE? Page 29 of 37 June 10.Which model you use depends on what market you deal with. diffuse over longer times. It’s hard to test options models under the best of circumstances. • There is no single correct replacement for Black-Scholes. • Interest rates have volatilities that depend on interest levels. 2003 .

2003 .VI VI IS THE SMILE FAIR? IS THE SMILE FAIR? Page 30 of 37 June 10.

= 7. (a) pre-1987 crash (1/70 to 1/87).8% std. = 7.8% 4 Probability (%) 3 Probability (%) -20 0 20 2 VI IS THE SMILE FAIR? 1 0 0 1 2 3 4 5 6 -20 0 20 Index Return (%) Index Return (%) 24 Fair estimated volatility skew. observed return distributions.and Post-Crash SPX Return Distributions Three-month. S&P 500 index. 2003 .3% std.Pre.3% mean = 3. post-crash pre-crash 10 90 12 14 Volatility (%) 16 18 20 22 95 100 Strike Level 105 110 Page 31 of 37 June 10. div. div. (b) post-1987 crash (6/87 to 6/99) mean =1.

VII VII TRADING & PRICING VOLATILITY USING VOLATILITY SWAPS TRADING & PRICING VOLATILITY USING VOLATILITY SWAPS The cleanest and easiest way to trade volatility is through a volatility swap. Swaps have become very popular because dealers have access to a theory for pricing them relative to the options market. which is a forward contract on realized volatility. The theory provides a basis for defining volatility indexes like the VIX in terms of the price of a basket of options that can be traded. Page 32 of 37 June 10. and for creating your own volatility swaps. 2003 .

Analogy: Credit Default Swap Market Corporate Bonds Bond prices are influenced by interest rates and credit spreads Credit default swaps allow you to simply bet on credit spreads VII TRADING & PRICING VOLATILITY USING VOLATILITY SWAPS Why isn’t there a market for volatility alone? Hedged Options Options prices are influenced by stock prices and volatility Volatility swaps let you trade pure volatility. 2003 . Page 33 of 37 June 10.

VII TRADING & PRICING VOLATILITY USING VOLATILITY SWAPS K vol : previously agreed upon “delivery” volatility.Volatility Contracts : Volatility and Variance Swaps A Volatility Swap is a forward contract on realized volatility: Payoff: ( σ R – K vol ) × N where N is the notional amount. Variance swaps are easier to price and hedge using options. and the annualization factor. σ R : realized volatility realized by the index until expiration. without the hassle and errors of hedging options. A variance swap is a forward contract on realized variance. But you want to understand how to price it! Page 34 of 37 June 10. It pays  σ2 – K  × N var  R Must specify the precise method for calculating realized volatility. You can trade volatility in one market or sector against another easily. the source and observation frequency of prices. 2003 . A dealer will sell you a variance swap.

∫ Γ S  σ – Σ  ∆t   2 An option whose ΓS VII TRADING & PRICING VOLATILITY USING VOLATILITY SWAPS = 1 would exactly earn the realized volatility 2 over the life of the contract. 2003 .Dealers create a variance swap by hedging a Log Contract Trading a single option: 2 2 2 1 Net P&L = -. • What kind of option has a 2 Γ∼1⁄S ? 2 Γ 1/S2 call S • An option whose payoff is the natural logarithm of S: – ln(S) payoff call ln(S) S Page 35 of 37 June 10. with a delivery price equal to Σ .

It will be equally sensitive to volatility at all spot level S.Dealers Can Create a Log Contract Out of A Basket of Options with Many Different Strikes A portfolio of vanilla options with weights inversely proportional to their strike squared can replicate the payoff of a Log Contract.100.120 VII TRADING & PRICING VOLATILITY USING VOLATILITY SWAPS A density of puts and calls will give the same payoff as a Log Contract. It will be equally sensitive to volatility at all spot levels 1/K2 equally weighted (a) (b) weighted inversely proportional to square of strike 20 60 100 140 180 20 60 100 140 180 strikes 60 to 140 spaced 20 apart (c) (d) 20 60 100 140 180 20 60 100 140 180 strikes 60 to 140 spaced 10 apart (e) (f) 20 60 100 140 180 20 60 100 140 180 strikes 20 to 180 spaced 1 apart (g) (h) 20 60 100 140 180 20 60 100 140 180 Page 36 of 37 June 10. 2003 . strikes: 80.

but needs a model for the volatility of volatility Page 37 of 37 June 10. Its value depends not just on volatility. • In practice you cannot buy very out-of-the-money strikes. You can create your own variance swaps like this to do vol arbitrage. and is a more complex derivative of variance. • If the stock jumps rather than moves smoothly. if the stock price moves too far. your replication will fail. 2003 . So. • The fair price of the variance swap is given by the market price of the basket of puts and calls. This is possible too.Pricing of Variance Swaps • Dealers replicate the log contract by buying and hedging a portfolio of puts and calls (and a forward contract). VII TRADING & PRICING VOLATILITY USING VOLATILITY SWAPS Difficulties to be aware of • You need a continuum of puts and calls of all strikes to replicate it exactly. Volatility is the square root of variance. and you have to dynamically hedge it by trading variance swaps as the underlier. there are additional replication failures Volatility swaps are more complex. a price which depends on the smile. but on the volatility of volatility.

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