Seeking Safety in Volatility Trading

By Chris McKhann

NEW YORK--While I am here at the Volatility Trading Summit, much of the talk has been about risk management.

Hedge funds typically like to sell volatility. It is a strategy that makes money most of the time, and so it appeases both the psyches and the investors. But it is also something I have spent much time discussing because it as risky as it is tempting. Just look at Jon Meriwether and Long Term Capital Management, the huge hedge fund blow up of 1997.

Many of you have heard the statistic that 80 percent of options expire worthless. Despite the fact that it isn't true--70 percent of options that make it to expiration expire worthless--it makes selling strategies very appealing.

But is there a way to be a volatility seller and still be hedged? That appears to be the ultimate question for professional volatility traders.

Some seem to think that the answer is no. Aaron Brown, the risk manager with AQR Capital, one of the best known and largest quantitative hedge funds, feels like risk is just part of the game.

His basic idea is that you must take risk to get returns and that you "cut the meat" out of your returns by using protection. "We need people to take chances and fail," he says.

Brown believes that it is good for the system, though clearly it is not good for the individual traders or firms (though I guess that depends on one's perspective). But I don't think Brown believes in blind risk-taking, and others clearly have much more risk aversion.

James White, a managing partner with Excelsior Capital, arguest against even using put ratio spreads because of the downside risk that they carry. He recommended using butterfly spreads instead. (As an aside, we have seen a lot of both types of trades in institutional size over the last year.)

Finally there was a very interesting presentation by Peter Carr, the head of quantitative research at Bloomberg. I will discuss this more later, but the general idea is that short volatility got crushed in 2008 but still outperformed the equity markets over the last 10 years. Another other point is that a dynamic strategy may be able to give the benefits of short volatility but avoids the big pitfalls.

This last strategy was discussed in the variance swap market, not something we have access to. But there may be ways to replicate the strategy, at least in a sense, using the VIX options. And that is the crux of what I came away with. The VIX options may just be the key that allows traders to be short volatility, but also hedged against that damned Black Swan.

(Chart courtesy of tradeMONSTER)

Comments

[mgarrett:]

This is slightly off topic. During the most recent period of volatility (the last 2 weeks), their has been a significant degree of predictive accuracy in looking at the swings between premium and discount in the front month Vix futures and the index. The nov contract was reading such a discount it created both a great indication as well as some low risk trading opportunities. That being there continues to be a discount in the front (nov), would you view that as a strong indicator that Ivol will continue to come in and equity markets stabilize?

Nov 05 11:31 PM

[aussiereader4:]

I only trade in volatile markets. It is the only reliable way of excluding both bulls and bears from the decision. It really does not matter what happens.

Nov 06 02:32 AM