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Towards a Theory of Volatility Trading

30 May 2011

Article by: Peter Carr and Dilip Madan
Published by: NYU
Date: 30 Jan 2002

“The primary purpose of this article is to review three methods which have emerged for trading realized
volatility. The first method reviewed involves taking static positions in options. The classic example is
that of a long position in a straddle, since the value usually increases with a rise in volatility. The second
method reviewed involves delta-hedging an option position. If the investor is successful in hedging away
the price risk, then a prime determinant of the profit or loss from this strategy is the difference between the realized volatility and the anticipated volatility used in pricing and hedging the option. The final method reviewed for trading realized volatility involves buying or selling an over-the-counter contract whose payoff is an explicit function of volatility. The simplest example of such a volatility contract is a vol swap. This contract pays the buyer the difference betweeen the realized volatility3 and the fixed swap rate determined at the outset of the contract.”

Full article (PDF): Link

 
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Posted in Realized volatility, Trading ideas

 

A Tale of Two Indices

24 May 2011

Article by: Peter Carr and Liuren Wu
Published by: Journal of Derivatives
Date: Spring 2006

“In 1993, the Chicago Board of Options Exchange (CBOE) introduced the CBOE Volatility Index. This index has become the de facto benchmark for stock market volatility. On September 22, 2003, the CBOE revamped the definition and calculation of the volatility index and back-calculated the new index to 1990 based on historical option prices. On March 26, 2004, the CBOE launched a new exchange, the Chicago Futures Exchange, and started trading futures on the new volatility index. Options on the new volatility index are also planned. This article describes the major differences between the old and the new volatility indexes, derives the theoretical underpinnings for the two indexes, and discusses the practical motivations behind the recent switch. It also looks at the historical behavior of the new volatility index and discusses the pricing of VIX futures and options.”

Full article (PDF): Link

 
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Posted in Implied volatility

 

Vix settlement weirdness

19 May 2011

Article by: Izabella Kaminska
Published by: Financial Times
Date: 19 May 2011

“News comes our way of there being some concern in the market about the Vix settlement process.

“In one phrase: It’s off.

“That is to say, it is not settling as it ought to.”

Full article: Link

 
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Posted in Implied volatility

 

Modelling the Impact of Overnight Surprises on Intra-daily Volatility

15 May 2011

Article by: Giampiero M. Gallo
Published by: Universita’ degli Studi di Firenze
Date: 2001

“In this paper we evaluate the impact that stock returns recorded between market closing and opening the next business day have on intra-daily volatility. A simple test shows that the estimated volatility clustering of the intra-daily returns may be affected by a market opening surprise bias. An extension of the standard GARCH model is suggested here to include the effect of this surprise and is applied on a sample of largely traded US stocks. The performance of two specifications in which this effect is included is evaluated in an out-of-sample forecasting exercise relative to their standard counterparts.”

Full article (PDF): Link

 
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Posted in Realized volatility

 
 
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