EQUITY INDEXES
EQUITY TRADING TECHNIQUES
Making volatility work for you
BYiVIARCO ERLiNG AND JOERG ZIMMERMANN
Volatility strategies on index-based contracts can deliver more reilabie
returns when the implied correlation is considered.
E
quity volatility short positions
are employed mainly in the index
space, rather than on single stocks.
This strategy tends to be more profitable
because, empirically, index volatility
often appears to be more expensive. But
is there a reliable indicator for the over-
valuation of index relative to single-stock
volatility? How could a possible mispric-
ing be exploited most efficiently?
Exploiting mispricing
impiied versus reaiized
Dispersion
With respect to those issues, the
implied correlation should guide the
investor in his investment decision pro-
cess. Market participants, for example,
may follow the Chicago Board Options
Exchange's (CBOE) S&P 500 Implied
Correlation Index. In July 2009, CBOE
introduced this index to measure the
expected average co-movement of the
S&P 500 index components. Investors,
however, are not restricted to the
American market as option liquidity in
Europe, as well as Asia, has increased
substantially and thereby now offers
good investment alternatives.
Overseas opportunity
When looking at the attractiveness
of short volatility positions for three
48 FUTURES November 2010
different markets, the Dow Jones
Industrial Average, the Euro Stoxx 50
and the Hang Seng index, a comparison
ofimplied volatility versus subsequently
realized volatility shows that the Hang
Seng offers the best opportunities. The
difference of short-term implied to
realized volatility since 2008 for the
Hang Seng index displays the greatest
overvaluation of around two volatility
points on average. Due to high real-
ized volatility in the same time period,
the Euro Stoxx and Dow Jones reveal a
negative spread of-1 and -2 volatility
points, respectively.
Index volatility often is overvalued not
only in comparison to its realized volatily
but also versus single-stock volatility.
At this stage, a look into the details
of this obvious inefficiency in Hang
Seng volatility pricing may be helpful
to figure out the best way to profit. We
should seek to determine whether the
overpriced volatility of the single mem-
ber stocks or the overpriced implied cor-
relation is the reason for an overvalued
implied index volatility.
The latter case would indicate that
index volatility often is overvalued
not only in comparison to its realized
volatility but also versus single-stock
volatilities. A closer look at the differ-
ent indexes reveals that the difference
in implied to realized correlation for the
Hang Seng index is highest with around
0.1 correlation points on average since
2008 in contrast to only 0.01 and 0.03
for the Dow Jones and the Euro Stoxx
50. Overvaluation is usually quite stable
except for times of financial turmoil, a.s
in mid-2008 when realized correlation
increased dramatically as equity mar-
kets were falling (see "Implied versus
realized," right).
There are two ways for a trader to
profit from this insight: One is sell-
ing index volatility. This could be done
through a covered call writing strategy
or selling (ideally delta-hedged) plain
vanilla index options. Because of usu-
ally overvalued implied correlation,
the strategy should earn higher prof-
its if implemented solely with indexes
instead of single stocks. The second wa\-
is by taking a short correlation position
through a dispersion strategy. This
solution is less sensitive to changes in
volatility movements. Different imple-
mentation alternatives exist. In an ini-
tial delta-neutral strategy, the investor
would take a short position in index vol-
atility and an offsetting long position in
the index members'volatilities.
The advantage of a dispersion strategy
over a simple volatility short strategy is
that it is neutral to volatility valuation
so that the profit and loss depends only
on the realized correlation. In contrast,
even if the expectation of an overval-
ued correlation proves to be correct,
the short volatility strategy can still
lose money. If the single-stock volatili-
ties are strongly undervalued, the index
N'olatility still can be too cheap despite
expensive correlation.
A market analysis shows that inef-
ficiencies are most significant for the
Hang Seng and even persistent in times
of financial turmoil, making this mar-
ket most suitable for such a strategy.
Furthermore, overvaluation of correla-
tion is more persistent in different mar-
ket environments than mispricing of vol-
atility, which makes a dispersion strategy
the best way to profit constantly.
Trade setup
Options provide a good vehicle for exe-
cuting a profitable dispersion strategy
on the Hang Seng index. The overvalued
index correlation is sold via selling an
at-the-money straddle on the index. To
offset the exposure to the overall level
of volatility, straddles on all the index's
members (the single stocks) are bought.
Obviously the short index straddle
IMPLIED VERSUS REALIZED
The difference between implied and realized correlation is somewhat stable, except pos-
sibly In periods of extreme financial disruption, as during the 2008 financial crisis.
Implied versus Reaiized Correlation of the Hang Seng Index
Realized
Correlation
index often exhibits a high
discrepancy between implied
and realised correlation
0.2
0.0
Jan 08 Apr Jul Oct Jan 09 Apr Jui Oct Jan 10 Apr Jul
Source: Bloomberg
positions will win the option premium cost 8.79% of the index spot versus
and lose the final option payoff. The 10.46% for the weighted average of the
position will earn money if the index does single stock (see "Profits from overval-
not move too far in one direction. The ued correlation," page 50). Ifyou assume
opposite is the case for the single-stock a correlation for the straddle of around
straddles. Therefore, the strategy will 0.6, a value that equals approximately the
earn money whenever the index members realized correlation for the index in the
show stronger moves than the index itself past years, the price of the index straddle
in relation to their movements implied would drop to 8.03% while the prices for
by their volatility pricings. the single-stock positions would stay
Based on data from July 30, 2010, a constant. As the index position would
straddle on the Hang Seng index would start losing money earlier because of

Understanding implied correiation

n the same way that market participants often use that the correlation between each asset is equal, the

I implied volatility as an estimate of future realised vola- market values for the weights and implied volatilities in
tility, implied correlation can be interpreted as an esti- the formula determine the value of the average implied
mation of the future co-movement of stocks in an Index. correlation:
One can derive the value by using the formula for the vari- ,
anee of an index of individual stocks: ^;,,,A.V ~

with W. as the weight for asset i in the index, cr. the The realized correlation for the assets in an index can
volatility of asset i and A , / as the correlation between be calculated in the same way by exchanging the implied
assets i and j . Under the (admittedly strong) assumption with realized volatilities.

futuresmag.com 49
EQUiTY TRADiNG TECHNIQUES continued
PROFITS FROM OVERVALUED CORRELATION
When correiation is overvaiued, the index tends to move iess than is impiied by
the straddie.
Short Straddle on Hang Seng
-3.000
17000 19000
spot movements, the portfolio offers a
significantly better risk-return profile
than theoretically justified.
The expected payoff of the portfolio
TRADiNG TECHNiQUES continued
Trading Techniques: McCurtain continued from page 46 •
time as stock m a r k e t prices a n d t h e n sto-
chastics rise, so m u c h the better. If equi-
ties are weak w h e n industrial p r o d u c t i o n
data are strong, for example, different
conclusions can be inferred. Sometimes,
though, the fundamental data signals will
be out of synch with equity market prices.
The analyst then tries to determine the
importance ofthe disparity by looking
for the next point of synchronicity, which
could offer new opportunities.
With analysis underway, it is impor-
tant to know that when combined with
a second fundamental data stream, such
as housing starts, two separate markets
are being considered. Improvement in
housing starts, for example, could have
a positive effect on the earnings of home
builders, on employment in general and
on retail sales as consumers ramp up
home-related purchases leading to a
commensurate rise in the prices of relat-
ed equities. Then there are those points
when the relationship dissipates, which
50 FUTURES November 2010
21000 23000 25000
Source: Bloomberg
is approximated by the difference of the
option premium received by the market
value ofthe index straddle and the theo-
retical value of the straddle based on the
happened in early 2006. Starts peaked
and housing construction and real estate
prices sank. But it wasn't until nearly a
year and a half later that the broad stock
market began a major decline.
It is possible that economic data can lead
equities and be measured by slow stochas-
tics or other classic technical analysis indi-
cators, despite historical presumptions.
When both economic data and stocks are
oversold, the odds are good both will rise
thereafter on the longer term. Notice also
that when industrial production remains
strong and the stock market is declining,
equity weakness may be suspect. Such a
bias has been the case many times with
industrial production since 1920. While
this information has little practical short-
term value, knowing the status of major
trends can help you avoid some pitfalls of
long-term investing.
While technical analysis has been tra-
ditionally applied to data in the finan-
cial markets, primarily equities, there
fair correlation value. In our example,
the market value ofthe straddle based
on a correlation of 0.73 is 1,832 while
the valtie based on a correlation of 0.6
would be 1,674. If our prediction of a
correlation of 0.6 turns out to be cor-
rect, the investor cotild expect a profit
of 1,832- 1,674 = 158.
The relationship between realized and
implied correlations is an important
one for traders to understand. It often
reveals unique trading opporttinities in
fresh markets — in this case, the Hang
Seng index — and dispersion strategies
offeraperfect way to profit. n
Marco Eriing and Joerg Zimmermann work as
portfoiio managers for structured products with
HSBC Globai Asset iVianagement. They man-
age voiatiiity products. Eriing has an MBA from
ESADE Business Schooi in Barcelona and can
be reached at Marco.Erling@i-iSBCTrinkaus.de;
Zimmermann has a degree in business from
the University of Coiogne. He can be reached
atJoerg.Zimmermann@iHSBCTrinkaus.de.
is a wide array of economic and fun-
damental data that can hold a wealth
of information when technical indica-
tors are similarly applied to that data.
Knowing the status of an economic
series as compared to a traditional stock
market index, such as the DJIA or the
S&P 500, can provide a useful perspec-
tive on not only the stock market, but
also the economy. Simply put, while the
argument will no doubt continue as to
which market approach, technical or
fundamental, offers the best approach
for traders, statistical knowledge based
on the application ofthe same indica-
tors to apparently unrelated streams of
data on a similar cycle could provide
answers that no true believer in either
camp might imagine — or deny. D
Robert McCurtain is a technical analyst,
market timer and private investor based
in New York City. He can be reached at
traderbob@nyc.rr.com.
Copyright of Futures: News, Analysis & Strategies for Futures, Options & Derivatives Traders is the property
of Summit Business Media and its content may not be copied or emailed to multiple sites or posted to a listserv
without the copyright holder's express written permission. However, users may print, download, or email
articles for individual use.