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Hedge Fund Monthly

Viva Volatility!

Simon Osborne, Asian Investor
May 2008


Market volatility has increased tremendously and traders love it. Volatility has exceeded recent highs, and in certain instruments such as Hang Seng futures and options, has reached all-time highs. Indices have been going up and down in large amounts, not just for limited bursts but continuously.

Is it time to start trading volatility? Unfortunately not, because that train has left the station already.

If you were not already positioned with a long-biased view on volatility before those markets started gyrating, it is now too late to do so, unless you pay through the nose for it. Trying to buy volatility has become a lot more expensive, for example, in the form of higher options premiums.

So what happened to those hedge funds smart enough to have been positioned long in volatility?

The Artradis Barracuda fund and its leveraged counterpart AB2 both maintain a long-volatility bias all the time, which Artradis expresses through the use of derivatives. The Artradis Barracuda Fund was up 35% in 2007 and AB2 was up 57%.

“We dial up and down the extent to which we are long volatility,” says Julian Ings-Chambers of Artradis. “Now we’re roughly in the middle, not as aggressive as we were, because the price of options has gone up. Markets now need to fluctuate more in order to make money from options and if markets fail to make those incrementally larger moves, then you risk losing money by having gone long volatility.”

Anyone who went into this period long volatility should be doing well. Trading desks and hedge funds are typically buyers of volatility, while their clients are typically sellers. Going long in volatility simply implies that you think the instrument or index will go up or down a lot and is not a directional trade. It is the amplitude of movement over time.

“We built volatility positions across the region. I run quite a concentrated, and on the whole, stock-specific strategy,” says Matt Barnett of Hong Kong multi-strategy fund Dragonback Capital. “The criterion for basic entry is that I have to know the stock well both fundamentally and technically, I have to have a directional view and the entry level has to make sense. Quite often it will be a discounted opportunity that is the initial catalyst to look closer at a trade.”

In the past, if you wanted to go long volatility, you would have done it via an option, typically a long straddle. If you thought volatility would quiet down, then you shorted the straddle. As a writer of that pair of options, you were exposed to greater potential risk, but in return for receiving premium income.

Variance swaps are probably now the preferred way of taking a view on volatility given that they give the most amount of leverage without having to put anything up front. However, it still depends on the risk/reward ratio. With buying options, you cannot lose more than your initial investment in the premium, whereas with a swap you can, because you are setting a benchmark, receiving above and paying below, or the other way around.

The variance swap is a way to position long or short exposure to market volatility, creating a directional view of volatility. Whilst it is called a swap contract, its characteristics have more in common with an option-based product.

“Variance swaps are an easier and cheaper way of taking positions on volatility,” says Nicolas Cohen-Addad, executive director of equity derivatives at Barclays Capital. “From an investor’s point of view it doesn’t require any daily dynamic delta hedging or any rolling of position due to market moves.”

When trading variance swaps, the trader is quite insensitive to the level of the market. Cohan-Addad explains further, “Gamma stays identical across the life of the product, whereas with options and fixed strikes the ‘Greeks’ move a lot. With variance swaps you don’t need to rebalance your portfolio to keep the same exposure.”

Volatility prices have gone through the roof in Japan. Implied volatility for short-dated options can be 40% and sometimes over 50%. That is only the fourth time this has happened in the last ten years, firstly during the fall of LTCM in 1999, then a brief period in 2000 and then post-11 September 2001.

Investors like the Phalanx Japan Australasia Multi-strategy Fund have been using strategies such as buying bonds or stocks, either individually or in a basket, and simultaneously selling index volatility. Then if half of the stocks go up and half go down, the index will stay the same but the hedge fund makes money on the volatility and differentials of the individual long positions, which have shifted around.

“Volatility does revert to mean, that’s a historical fact,” says Chris McGuire of Phalanx from the US. “I think volatility will persist for several months but eventually hedge funds will think about taking short volatility positions. You might want to pay 45% for shorter term volatility positions, say six months or less, but that pricing isn’t attractive for options over six months in duration.”

Dispersion Diversion

What about trading mid-term volatility now though? That depends if you believe that the worst is behind us, or the worst is yet to come. If you think the latter, then it is still not too late.

If you think that taking an outright long volatility position is too pricey, then a way you can express one view at a cheaper price is via such a dispersion trade.

Imagine an Olympic race, the Kenyans and Moroccans are out front as usual, and the Europeans are being lapped. The further out the outliers – the speedy African runners, in our analogy – the greater is the ‘dispersion’.

When markets move in unison, such as they are doing now, correlation is high and there is not much dispersion, so the sort of trades that hedge funds will be putting on right now are dispersion trades, because if volatility slows down, some stocks will perform and move differently from others. Today, everything is moving either up or down in approximate unison.

A typical dispersion trade involves a hedge fund buying at-the-money straddles on the individual components of a basket or index and selling an at-the-money straddle on the basket or index itself.

The idea is that some of the individuals perform in different ways, some up and some down, and as long as that dispersion exceeds the average amount of movement in the basket, you can make money.

This kind of trade is the holy grail for customer trading desks, where investors such as private banking clients have been selling volatility to investment banks. So when a customer buys a note on a basket of stocks, that investor has sold volatility and bought correlation; the investment bank in turn is long volatility and short correlation.

Volatility is easier to hedge than correlation, because with volatility you can go out and do variance swaps. If you have a warrant book, you can sell volatility via warrants, or if you have a hedge fund desk, you can sell volatility to hedge funds or to other banks.

That does not take care of the correlation, because when an investor buys a basket product, the seller is still short correlation and when there are 10% moves up and down, the structurer can get into trouble. At the moment, it is almost impossible to hedge correlation, unless the investment bank can find an offsetting trade with a hedge fund, which is quite rare. Banks want to find a way to offset short correlation and in theory that could be trying to find ways of selling it back to retail, but practically it is impossible and they end up underwater on the trade.

When volatility calms down, one signpost will be the arrival of new structured products, which by and large tend to reward investors when there is a lack of volatility. In the current scenario, fund managers have seen knock-out structures where the investor gets nothing if a certain level is reached. A high-volatility scenario would have led to the knock out of those structures.

In the foreign exchange market, volatility structures such as wedding cakes are popular. That is where you have several trading ranges. If your currency pair stays within one range you get a certain coupon, while if it stays within another narrower range, but in a volatile market, even lower coupons are being knocked out.

So trading volatility is now expensive and nobody wants to be left dancing last at the party. What can people looking to profit today do? A strategy could involve a call-spread option, digital options or perhaps simply a return to good old-fashioned relative value trades.

This article first appeared in the March 2008 edition of the Asian Investor magazine.

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