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"The problem is that we’ve not just seen higher volatility but that volatility itself has been very volatile"
Abhinandan Deb, Barclays Capital |
Volatility trading has been booming in recent years as hedge funds and a growing number of traditional fund managers have turned to volatility products, particularly variance swaps, for trading opportunities negatively correlated to equity markets.
Aite Group, a consultancy, estimates that variance swap trading volume growth could hit more than 100% this year. The product, which trades volatility squared and is particularly useful for mapping the volatility profile that is typical in equity and equity index options, is the fastest-growing segment in the volatility swap product set. However, it is being hit by extreme market movements that have scared liquidity out of the market.
"The problem is that we’ve not just seen higher volatility but that volatility itself has been very volatile – this too has impacted liquidity in equity derivatives and other markets," says Abhinandan Deb, a volatility analyst at Barclays Capital. "Single stock variance swaps have been particularly affected because of a combination of factors. The introduction of short-selling restrictions created a lot of uncertainty about which stocks were affected. We also saw volatility in certain stocks jump two to three times. As a result, a lot of single stock variance swaps capped out."
Variance swap contracts typically have a cap on their maximum possible loss of 2.5 times to limit losses because theoretically variance can reach infinity. The fact that many of these caps were hit for contracts on single stocks has hit hedges put in place and is leading traders to reassess how they price such caps.
Although liquidity in variance swaps on indices has held up better, heightened fears over counterparty risk have also driven more volume into exchange-traded products.
With volatility now high but range-bound, some traders are adopting complex trading strategies designed to profit from directionless markets and limited downside.
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Volatile volatility |
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Vix volatility index |
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Source: CBOE |
"There’s not much risk appetite out there from either hedge funds or real-money investors," says Deb. "Nevertheless there are trades that could make money in this environment, like butterfly option strategies."
A butterfly option strategy involves going short a straddle, that is, holding a short position in both a call and a put that have the same strike price and expiration date, and going long a strangle, that is, holding a position in both a call and put with different strike prices but with the same maturity and underlying asset.
The combination of the two allows an investor to get a premium from the straddle being sold when volatility is high while limiting potential losses.