Article / 20 November 2014 at 0:30 GMT

Multi-asset options 1 - the role and use of volatility

Global Macro Strategist / Saxo Bank Group - Singapore Hub
  • The two biggest drivers of options prices are the underlying asset, followed by volatility
  • Volatility is just a set of data points in the quest for looking to the best risk-reward skew
  • You don’t have to hold things until maturity, you can position up a week, day or hour

By Kay Van-Petersen

In the first part of a series of works focusing on options we’ll set the background on volatility and follow up with two to three pieces focused on trading ideas. I am currently thinking something around Gold and the Swiss referendum or potentially USDJPY – feel free to comment on what you’d potentially want to be touched on. These will be a little chart heavy, as this is key for providing context and greater association for where we are in the markets.
Do note that finance - and investing in particular - are areas where there are always exceptional cases, yet here I am talking about things in a general context, so bear that in mind.

For those looking for more basics on options, we’ll be uploading a concise primer put together by our very own Patrice Henault together with other Saxonian derivatives (pardon the pun). You can follow Patrice on TradingFloor.Com, and here is an example of an elegant piece he penned together on the basics of Covered Calls. He also puts out quite a few trading recommendations on option strategies. For more information on the new Saxo Capital Markets' Stock Options primer see here and the stock options product guide attached to this piece.

So what exactly is volatility and why is it so important when discussing options and options strategies?

Put very simply, the two biggest drivers of options prices are the underlying asset, followed by volatility. Yes interest rates, yield and time play a factor but nowhere near as big as volatility. Picture an empty room, with a red ball flying across the room. The speed and direction change of the ball denotes volatility. If the ball sails across the room in a lazy one-directional pathway, volatility is low. If it shoots across the room at great speed and in a variety of changing pathways, volatility is high.

When discussing and analysing volatility, it's worth keeping in mind that like technical analysis, fundamental and valuation ratios, balance sheet numbers etc, volatility is just another set of data points in the quest for looking to the best risk-reward skew. It's not as simple as, let's sell volatility when implied volatility (IV) is higher than realised volatility (RV) – also known as historic volatility.
RV is backward looking and captures the historical path of how volatile an asset’s price has been. IV is a current to forward looking metric and one arrives at this measure by deducting volatility from the price of the option. To put it another way, you take option pricing formula such as the Black Scholes, and then solve for volatility (ie inputting everything else into the box: option price, spot, strike, expiry and interest rates).

You're either risk on or risk off: In many cases when trading, you sometimes just know things could move and move big: Photo: Thinkstock

So in the markets volatility tends to act as barometers of risk-on (low uncertainty) and risk-off (high uncertainty). Generally when volatility is very high after a big drop in the market, investors are very nervous and the thinking is defensive, as there are probably people sitting with losses on their books. Conversely when volatility is low, investors tend to be risk-on (a case can also be made for indecisive as they shuffle back and forth or stay on the side-lines).
However when talking about volatility and trading strategies in general, one is either risk-on and therefore short volatility, say if one owned a basket of long only positions in equities. Or one is risk-off and therefore long volatility (expecting the market to correct or crash and volatility to spike up).

This is an important concept of how to think and look at not only one’s trading strategies, but also how one’s portfolio is constructed. For instance, you may only own utility and healthcare names, with the thesis of being positioned defensively because you expect a market correction. On one level of risk management, you are potentially better protected on a relative basis versus other equity holders who may be long cyclicals and financials. At a higher level of risk management, you are still short volatility. So even if your thesis plays out correctly and the market corrects sharply, you’ll lose money even if on a relative basis you outperform.

How can one play volatility?

There are four basic ways to take a view on volatility, one either expects volatility to :
  • Move up (expected risk-off)
  • Move down (expected risk-on)
  • Not move much (expected neutral price action)
  • Some combination of the above three (e.g. Expecting correction from 100 to 92-95 region, but very strong support at the 90 level etc)

Why would one want to play volatility?

There are a number of key reasons here and three elements spring to mind.

Through buying options and going long volatility through either straddles or strangles, one knows their finite level of risk - ie the most they can lose is the premium they paid for the trade. So money/risk management of the single trade is an element.

The second element is linked to the first but tied to hedging or protecting the entire portfolio. So for instance, let's say you're up +25% for the year and have an aggressive long equity portfolio and are short bonds. You may believe in a Santa rally, so you don’t want to take any exposure off, yet the last thing you need is to lose a big portion of your profits with only a few weeks left in the year. So you buy year-end or Jan straddles on the S&P 500 or Nikkei, so if there is a correction, your long volatility position should hedge the draw down in your long equities short bonds risk-on portfolio. So portfolio risk management is another element.

The last element for me is tied to catalysts and inflection points in the markets, whereby one knows there is something key and a potential trigger, yet for one reason or another it's too hard to call a direction – you just know that things could potentially move and move big. Long volatility plays can be an inexpensive way of taking on these calculated risk and if there is a non-event, one can close the trade right after and net net one is only paying away the spread on the option prices, all other things being equal.

The point I am trying to make here is, you don’t have to hold things until maturity, you can position up a week, day or hour into something and close it right after the event. So event-driven and special situation type points is another element where volatility can be a great way to participate.

How does volatility relate to different asset classes?

Volatility is a symmetrical factor that exists in all asset classes or forms of investment. Whilst volatility is interrelated, it's far from a convergence. For instance, soon after joining the Saxo Spaceship, I released this piece on TradingFloor.Com, calling for the structural low in volatility and highlighting that it was back in the currency markets. Since then volatility has rippled through the equities, credit and commodities classes as well. I like to think of these broad asset classes as pools of water interlaced with one another, the bigger the ripple in one, the greater the effect on the other. A good example of this was the Scottish Referendum earlier this year, whereby the ripples seemed to spill from GBP to gilts to UK equities.  

Where is volatility now?

As can be seen by a number of charts below, we’ve gotten to very low levels of volatility from a historical basis (context is always important when discussing volatility). If we take equity volatility measured by the VIX on the US S&P 500, we are at 13.86, around a 70% discount to the 24 year average of 20.20. As can be seen on the year-to-date chart, just because we are at structural historical lows in volatility does not mean we cannot have big swings in volatility (not to mention, profitable long volatility plays).
VIX - 24 year equities volatility
VIX - year to date equities volatility
 Charts source: Bloomberg

The year closing highs and lows on the vix were 26.25 and 10.32 respectively. Whats interesting is that post the October correction, Euro-zone volatility is still elevated in comparison to their US counterparts – and rightly so in my view.

The great divergence between the Eurozone and the US clearly being shown in the volatility readings of the S&P 500 and the EuroStoxx equities indices. Risk is still elevated in the Eurozone and rightly so
Source: Bloomberg

As can be seen from the stacked chart below, irrespective of what asset class one is discussing, currently volatility levels are well below the historical average across equity, credit and currency markets.

EQ-FI-FX stacked chart: Whether its equity, credit or currency volatility levers, we are still well off historical averages, let alone highs
 Source: Bloomberg

Is volatility high or low?

This is a great and perpetual question – yet a lower level of understanding in that it's very broad. A sharper question leads to a sharper answer.
- Is volatility high or low compared to XYZ? Context is needed.
- What asset classes are we looking at, or comparing against?
- What’s our reference time frame? (i.e. why look at 1 year volatility if you take 3 year or 3 month investment/trading horizons)
- What strikes and maturities are one observing? Is there similar option strategy that covers the same investment theme, yet vol is cheaper? And so on…

Context is key as well as bearing in mind that these are just another data point that goes into that trading or investment decision – at the end of the day we arrive at the same ratio, the risk/reward ratio.

In closing

I believe that 2014 will mark the structural low in global volatility, yields and inflation – as globally monetary policy as a whole starts to tighten after years of unprecedented printing (ie. US and UK exiting the printing press, Japan and Eurozone needing to go further in.
Volatility is linked to rising yields and I think we are going to be in multi-year runs of rising global rates, alongside a structural move in an ever strengthening USD. The latter by itself will increase volatility, particularly against commodities as an asset class (ie all commodities are priced in USD) and emerging market economies. 

As volatility increases, options – particularly on the FX side - can offer some very compelling risk-reward and portfolio protection alternatives.

So I am thinking our next piece will focus on specific option trading ideas around currencies, and potentially there will be an equity or index linked piece after that. Please stay tuned.

-- Edited by Adam Courtenay

Kay Van-Petersen is Asia macro strategist at Saxo Capital Markets in Singapore. Join the conversation below to be a part of the social trading phenomenon.
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