6 volatility trading strategies

By , CEO of Volcube.

Almost every volatility trading strategy can be characterised as one of the following 6 ideas. By volatility, it is important to distinguish between implied volatility (the expected future volatility as revealed by the options market) and actual volatility (the variability of prices of the underlying market). The majority of volatility trading involves plays on implied volatility.

1. Trading implied volatility against itself

Trading volatility because it is thought rich or cheap relative to its historical value. For instance, a trader might think the VIX looks cheap at 12%, given its 5 year time series, and decide to buy some equity index options or VIX futures in the hope that implied volatility rallies.

2. Trading implied volatility against actual volatility, as a vega play

The trader might notice that implied volatility is well above actual volatility and expect implied volatility to fall to correct this imbalance. Notice he does not expect actual volatility to rise. So, he might decide to sell some option straddles to become short vega. This position should be profitable if the implied volatility subsequently falls.

3. Trading implied volatility against actual volatility, as a gamma play

The trader again notices that implied volatility is above actual volatility. He may decide to try to play for the difference by selling options to become short gamma and theta-collecting. His strategy will involve gamma hedging and hoping that the subsequent losses from these negative gamma hedges do not outweigh his theta-collection profits. Of course, the reverse strategy (long options, long gamma, paying theta) is perfectly plausible when the trader expects actual volatility to exceed the implied volatility.

4. Trading implied volatility between options on different products : (relative value, vol-arb)

The trader notices an imbalance between the implied volatilities of options on two different products, relative to the historical relationship their implied volatilities have displayed.  If the trader expects the imbalance to be corrected, he may decide to buy options on one product and sell options on the other. It is common for the products to be fundamentally related in some one; such as two correlated equity indices. This gives the strategy a long-short character which can mean some of the unwelcome exposures are self-mitigated. For instance, the strategy might be constructed so that it is roughly vega-neutral; i.e. is relatively neutral with respect to the implied volatility level generally.

5. Trading implied volatility between options on the same product

Another relative-value idea. This might include skew trading for instance. A put may be traded against a call on the same product with the same expiration for instance. Again the motivation is that the relative implied volatility spread is thought to be high or low and will mean-revert. And again, many of the undesirable risk elements can be neutralised; for instance a put versus call strategy might be constructed to be vega and gamma neutral.

6. Trading implied volatility across the term structure

Expecting the implied volatilities of options with different expirations to re-align. This is yet another relative value idea with the possibility of being self-hedging with respect to unwanted Greeks. For instance, it would be possible to create a calendar (or time) spread using options on the same underlying but with differing expirations that is gamma and theta neutral. This might be desirable if it is primarily the implied volatility spread that the trader wants to gain exposure to.

Have a question for the author? Happy to help! Email [email protected].

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