Market volatility is back in case you haven’t noticed and institutional options traders are ecstatic. Volatility is the lifeblood of options trading as the heightened price activity typically leads to more trading and as a result greater commissions (if you’re on the sell side!). From an investor’s standpoint, volatility is not necessarily a good thing or bad thing but finding ways to monetize a view on volatility to either hedge a portfolio or for pure speculation hasn’t been the easiest thing to do. People often look to the VIX as the ultimate gauge of market volatility. The VIX, commonly referred to as the ‘fear gauge’, is calculated by taking an average of implied volatilities of front and next month S&P 500 options. Being that the VIX is an average of implied volatilities it cannot be traded as is. There are however, many instruments available to trade the VIX including: VIX futures, VIX options, VIX ETNs, options on VIX ETNS, etc… For institutions looking to express a view on volatility the purest way to implement such a view in the markets is by trading a variance swap.

What Exactly is a Variance Swap?

When an options trader buys or sells an option he/she is effectively expressing a view on the implied volatility of said option. If the trader believes the implied volatility of the option is less than the theoretical volatility the option should carry when pricing options using the Black Scholes formula (or binomial model) the trader is likely to take a long position in the option. If the trader believes the current implied volatility of the option is higher than the theoretical implied volatility obtained through Black Scholes or the binomial model (or other option pricing models) then he is likely to short said option. That’s why we say an options trader is long volatility when he buys options and short volatility when he sells options. However when you buy or sell a put or call you are also taking a directional position: buy a call, sell a put = Bullish; sell a call, buy a put = Bearish. For traders looking to express a volatility bias without taking a directional position they can buy/sell: 1) straddles/strangles, 2) options delta neutral, or 3) variance swap.

Straddle and Strangle Options Revisited

We covered straddles and the strangle option in the previous post, I Confess…I Enjoy Being Strangled, so I won’t go into great detail here. But basically the strategies involve buying a call and put with the same strike (straddles) or different strikes (strangle option) with the same expiration. These structures are delta neutral (meaning void of a direction bias) at inception and thus primarily are traded based on the volatility bias of the trader. However, straddles and strangle options quickly lose their delta neutral characteristic as soon as the stock moves away from the spot price. Thus the position needs to be altered over time to maintain a delta neutral stance.

Buying or Selling Options Delta Neutral

Another alternative in singling out and trading the volatility in an option is through delta neutral trading. In simple terms under a delta neutral strategy a trader would purchase a put or call and take a position in the underlying stock according to the delta of the put (call) to offset the direction bias of the option position. For example say a call option has a delta of 0.60, if a trader buys 100 contracts the position would be synthetically equivalent to being long (100 contracts x 100 shares per contract x 0.60 (delta) = 6000 shares of stock. In order for the trader to get rid of the direction bias of the long call position he must short 6000 shares of stock. This action would bring the portfolio to a delta neutral point for the moment. But as the stock moves around the delta hedge needs to constantly be adjusted requiring the trader to purchase or sell shares on a daily basis to maintain a delta neutral stance. The position profits in the end if the volatility of the option the trader bought ends up being less than the resultant realized volatility and the stock moves higher and lower and not just in a straight line (path dependency).

The Variance Swap

As you can see in the previously discussed options making a volatility bet using options requires constant monitoring and adjustment of the stock hedge.  However there is a strategy that allows for traders to express a pure volatility bias without the need to constantly manage an offsetting stock position: the variance swap. A variance swap is an over-the counter (OTC) product between 2 counterparties that agree upon the duration, dollars per volatility point, strike, and underlying security. In very simple terms, a variance swap is equivalent to betting the over/under in a football, basketball or other sporting game. If the trader wants to bet that the volatility of a stock is going to be higher than a specified volatility strike then he would purchase/ go long a variance swap and if the trader believed that the forthcoming realized volatility would be less than the specified volatility strike he would sell / go short a variance swap. The payout would differ from a standard over/under bet in that the amount of payout would be dependent on just how much over or under the resulting volatility ends up being over the volatility strike ($ per vol point). A payoff of a long variance swap is illustrated below. While there are some characteristics of the structure that may be of concern to some investors (counter-party risk, collateral requirements, bid/ask spread, etc..) the variance swap remains the purest way to trade volatility. For further information on the Variance Swap and other Options Trading Strategies visit OptionsUniversity.com.