Volatility Trading

Volatility trading is the practice of buying and selling financial instruments in order to gain from the degree of price fluctuation in a market. A volatility trader is concerned with how much an asset will move, or with how the market's expectation of movement will change, and seeks to remove or limit exposure to whether the price goes up or down. Volatility is treated as something that can itself be bought and sold.

The activity is carried out mainly through options and related derivatives. Participants include option market makers, hedge funds, the trading desks of banks, institutions seeking protection for their portfolios, and individuals using exchange-traded products. Positions are described as long volatility if they gain when volatility rises and short volatility if they gain when it falls or stays low.

Traders distinguish the volatility that has occurred from the volatility that is priced. Realized volatility is measured from the actual returns of the asset. Implied volatility is derived from option prices and reflects the market's expectation for the period until expiry. Most volatility trades are a view on one of two things: that future realized volatility will differ from the implied level, or that implied volatility itself will rise or fall.

A convenient rule converts an annual implied volatility into the daily move it represents:

Here $\sigma_{\text{annual}}$ is the annualized implied volatility and 252 is the approximate number of trading days in a year. The square root of 252 is about 15.9, so traders divide by 16. An implied volatility of 16 percent corresponds to a typical daily move of about 1 percent, and 32 percent to about 2 percent. A trader who buys options at 16 percent needs the asset to move more than about 1 percent a day, on average, for the purchase to pay.

• Options combinations. A straddle or strangle gains from a large move in either direction and is the simplest long-volatility position.
• Hedged options. An option position combined with delta hedging in the underlying removes directional exposure and leaves a position on volatility. Adjusting the hedge as prices move is gamma scalping.
• Variance and volatility swaps. These over-the-counter contracts pay the difference between realized variance or volatility over a period and a level fixed at the start, with no hedging required.
• Volatility index futures and options. Futures on the VIX, an index of implied volatility on the S&P 500 calculated by Cboe, began trading in 2004, and options on the index in 2006. They give exposure to expected volatility directly.
• Exchange-traded products. Funds and notes that hold volatility futures make long, short or leveraged volatility positions available through an ordinary brokerage account.

Long-volatility strategies buy options or volatility futures, either as protection for a portfolio or in anticipation of turbulence. They lose a little most of the time, through the daily erosion measured by theta, and gain substantially in a shock. Short-volatility strategies do the reverse, collecting premium in calm markets. Because implied volatility has on average exceeded realized volatility, a difference known as the volatility risk premium, short positions have been profitable over long periods at the cost of occasional severe losses.

Relative-value strategies compare one volatility with another. Volatility arbitrage sets implied against forecast realized volatility. Dispersion trading sets the volatility of an index against that of its member shares. Other trades compare different strikes or expiries on the volatility surface, for instance through a calendar spread.

A volatility book is run by its sensitivities. Vega measures exposure to implied volatility, and gamma measures exposure to actual movement. Long-dated options carry mostly vega and short-dated options mostly gamma, so the choice of expiry determines which kind of volatility is being traded.

Positions in volatility futures have an additional feature. Futures for later months usually trade above the current index level, a condition called contango. As each contract approaches expiry its price tends to fall toward the index, so a holder of long futures loses value over time if nothing else changes. Products that hold long volatility futures have for this reason lost most of their value over multi-year periods, apart from sharp gains during crises.

Short-volatility positions have limited gains and very large potential losses. Volatility can double within days, and it does so when other assets are falling and liquidity is poor. On 5 February 2018 the VIX recorded its largest one-day percentage rise, and exchange-traded products built to deliver the inverse of volatility futures returns lost most of their value; one of the largest was closed.

Long-volatility positions carry the opposite problem of a steady, predictable cost, which many investors find hard to sustain through long calm periods. All volatility positions depend on pricing models for their hedges, and gaps in the underlying price can leave a hedged position exposed. Regulators have warned that volatility-linked exchange-traded products are complex, intended for short holding periods and unsuitable for investors who do not understand how they behave.

• Cboe Global Markets
• U.S. Securities and Exchange Commission