Volatility Strategies

Issue #6, Hedge Hog

In previous issues, we focused on using RealVol Instruments to hedge exposure in the marketplace. In this issue, let's turn the tables and discuss how to hedge RealVol Futures and Options using other, well-established instruments.

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Issue #5, Spread the Wealth

Spreading RealVol futures against VIX futures may provide interesting short-term trading opportunities.  “… there may be some very interesting and potentially profitable spread opportunities between VIX futures and RealVol futures, whether using lagged or same-month contracts.”

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Issue #4, Over Hill, Over Dale, Overlays

In a paper published in October 2012,  Sixiang Li explained the concept of adding a volatility overlay to a buy & hold equity portfolio.  Mr. Li showed that continual hedging with a long volatility position would most likely not be a worthwhile endeavor.  However, adding a fairly simple moving-average indicator so as to adjust the allocation of a RealVol futures overlay showed interesting historical outcomes. Vol Strategies article #4 highlights some of Mr. Li’s most important findings.  Full article ...

Issue #3, Day-Trading Convexity in RealVol Futures

As one can see, RealVol essentially defines volatility as an absolute function. It is meant to capture the movement, not the direction, of some underlying asset. In addition, the RealVol daily formula is calculated using daily price movements, which means that the trades within the day are not considered in the calculation, and only the closing, or settlement, price matters. In other words, we are interested in the movement from yesterday's close to today's close.

At first glance, one may think that using only settlement prices doesn't thoroughly capture volatility. In fact, measuring returns just once each day captures volatility rather well. What is most interesting, though, is that measuring volatility using only close-to-close data creates a potentially profitable opportunity for savvy day-traders. Full article ...

Issue #2, Volatility Hedging — Turn Up the Static!

Until the advent of RealVol futures, the only way to offset some of the gamma and vega (also known as kappa) risk of an options book in a listed instrument was to trade more options. For a market-maker, crossing the spread to execute feels like "throwing money away." This is because the essence of marketmaking is to buy as close to the bid as possible, sell near the offer, and then manage the risk of the book, via hedging, to capture the small advantage.

RealVol futures, as we shall see, can play a major role in this hedging activity. However, even if it provided the best hedge possible, at present the RealVol futures market is in its infancy and not very liquid, which makes it difficult to use the product in a cost-effective manner for dynamic hedging. Full article ...

Issue #1, Four-Wheel Drivers of Volatility

There are four primary drivers of volatility prices. Two are generally longer-term effects (mean reversion and autocorrelation), while two are often short-term in nature (shocks and relief).

1. Mean Reversion — The tendency for values to move toward their long-term average, or mean.
2. Autocorrelation — The observed propensity for values to remain near where they have been in the recent past.
3. Shock — The change from a low-volatility environment to a high one, typically because of the occurrence of a significant, unforeseeable event.
4. Relief — The shift from the regime of an anticipated event to that of a known outcome.

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