Is Volatility Rich?
Derivatives-based Portfolio Solutions


Selling implied volatility is one of the most popular trading strategies in equity derivatives. Empirical analysis shows that implied volatility or variance is, on average, overpriced. However, as volatility is negatively correlated to equity returns, a short volatility (or variance) position is implicitly long equity risk. As equity returns are expected to return an equity risk premium over the risk-free rate (which is used for derivative pricing), this implies short volatility should also be abnormally profitable. Therefore, part of the profits from short volatility strategies can be attributed to the fact equities are expected to deliver returns above the risk-free rate.

As implied volatility tends to trade at a higher level than realised volatility, a common perception is that implied volatility is overpriced. While there are supply and demand imbalances that can cause volatility to be overpriced, part of the overpricing is due to the correlation between volatility and equity returns. A short volatility position is positively correlated to the equity market (as volatility typically increases when equities decline). As equities’ average return is greater than the risk-free rate, this means that the risk-neutral implied volatility should be expected to be above the true realized volatility. Even taking this into account, volatility appears to be overpriced. We believe that implied volatility is overpriced on average due to the demand for portfolio hedges.

Far-dated options are most overpriced, due to upward sloping volatility term structure. Volatility selling strategies typically involve selling near-dated volatility (or variance). Examples include call overwriting or selling near-dated variance (until the recent explosion of volatility, this was a popular hedge fund strategy that many structured products copied). As term structure is on average upward sloping, this implies that far-dated implieds are more expensive than near dated implieds. The demand for long-dated protection (i.e. from variable annuity providers) offers a fundamental explanation for term structure being upward sloping. However, as 12× one month options (or variance swaps) can be sold in the same period of time as 1× one-year option (or variance swap), greater profits can be earned from selling the near-dated product despite it being less overpriced. We note the risk is greater if several near-dated options (or variance swap) are sold in any period.

There are several fundamental reasons why volatility, and variance, is overpriced. Since these reasons are structural, we believe that implied volatility is likely to remain overpriced for the foreseeable future. Given variance exposure to overpriced wings (and low strike puts) and the risk aversion to variance post credit crunch, we view variance as more overpriced than volatility.
  1. Demand for put protection. The demand for hedging products, either from investors, structured products or providers of variable annuity products, needs to be offset by market makers. As market makers are usually net sellers of volatility, they charge margin for taking this risk and for the costs of gamma hedging.
  2. Demand for OTM options lifts wings. Investors typically like buying OTM options as there is an attractive risk-reward profile (similar to buying a lottery ticket). Market makers therefore raise their prices to compensate for the asymmetric risk they face. As the price of variance swaps is based on options of all strikes, this lifts the price of variance.
  3. Index implieds lifted from structured product demand. The demand from structured products typically lifts index implied compared to single-stock implied. This is why implied correlation is higher than it should be.

Hedge funds typically aim to identify mispricings in order to deliver superior returns. However, as both hedge funds and the total hedge fund marketplace grow larger, their opportunities are gradually being eroded. We believe that above-average returns are only possible in the following circumstances:
  1.  A fund has a unique edge (eg, through analytics, trading algorithms or proprietary information/analysis).
  2. There are relatively few funds in competition, or it is not possible for a significant number of competitors to participate in an opportunity (either due to funding or legal restrictions, lack of liquid derivatives markets or excessive risk/time horizon of trade).
  3. There is a source of imbalance in the markets (eg, structured product flow or regulatory demand for hedging), causing a mispricing of risk.

All of the above reasons have previously held for volatility selling strategies (i.e. call overwriting or selling of one/three-month variance swaps). However, given the abundance of publications on the topic in the past few years and the launch of several structured products that attempt to profit from this opportunity, we believe that volatility selling could be less profitable than before. The fact there remains an imbalance in the market due to the demand for hedging should mean volatility selling is, on average, a profitable strategy. However, we would caution against using a back-test based on historical data as a reliable estimate of future profitability.
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