(Dresdner Klein Wort, Bossu) Introduction To Volatility Trading and Variance Swaps

24 February 2007
Introduction to Volatility Trading and Variance Swaps

EQUITY DERIVATIVES WORKSHOP
University of Chicago Program on Financial Mathematics Sebastien Bossu Equity Derivatives Structuring Product Development
Disclaimer
This document only reflects the views of the author and not necessarily those of Dresdner Kleinwort research, sales or trading departments. This document is for research or educational purposes only and is not intended to promote any financial investment or security.
Volatility Trading and Variance Swaps
Introduction
Typical Trading Floor Instruments
Cash
Exotics Futures Options
Introduction
Typical Trading Floor Front Office
Trading Structurers Quants / Financial Engineers Research Marketing / Sales Economists

Key concepts behind Black-Scholes............................................................. 5 Black-Scholes in practice ............................................................................12 Managing an option book ........................................................................... 21 Trading volatility .......................................................................................... 27 P&L path-dependency ................................................................................ 39 Variance swaps ...........................................................................................45
Key concepts behind Black-Scholes

Why is Black-Scholes used in practice? Key strengths Key limitations
Why is Black-Scholes used in practice?

Derman: In 1973, Black and Scholes showed that you can manufacture an IBM option by mixing together some shares of IBM stock and cash, much as you can create a fruit salad by mixing together apples and oranges. Of course, options synthesis is somewhat more complex than making a fruit salad, otherwise someone would have discovered it earlier. Whereas a fruit salad's proportions stay fixed over time (50 percent oranges and 50 percent apples, for example), an option's proportions must continually change. [...] The exact recipe you need to follow is generated by the Black-Scholes equation. Its solution, the Black-Scholes formula, tells you the cost of following the recipe. Before Black and Scholes, no one ever guessed that you could manufacture an option out of simpler ingredients, and so there was no way to figure out its fair price.
My Life as a Quant, John Wiley & Sons, 2004
Key strengths
Sensible model for the behavior of stock prices: random walk / log-normal diffusion Intuitive parameters: spot price, interest rate, volatility Arbitrage argument: dynamic hedging strategy
Key limitations
True or False? Stock prices follow a random walk / a lognormal diffusion False Stock prices are determined by supply and demand which are influenced by countless economic factors. If a company announces bankruptcy, its stock price WILL go down with 100% probability.
Key limitations
True or False? If I buy an option at a higher price than the Black-Scholes price, I will lose money. False Different agents have different uses for options: Bets: individual investors, asset managers Hedging: corporate investors Volatility trading: traders, hedge funds
i.e Black-Scholes is not an arbitrage price in the sense that one loses money when trading at a different level (compared to forward contracts / futures where there is a strong (static) arbitrage.)
Key limitations
True or False? If I buy an option at a price higher than the Black-Scholes price and I follow the Black-Scholes delta-hedging strategy, I will lose money. False but in one case: False in practice: discrete hedging, jumps, stochastic volatility may have a positive impact on P&L False in theory: even if we assume that the realised stock price process is a lognormal diffusion unless we also assume that the realised stock price process follows a lognormal diffusion with the same volatility parameter as the one used to price the option
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So what is Black-Scholes?
NOT a good model for the real behavior of stock prices NOT a good model to determine the fair value of an option: different agents give different values to the same option NOT a good model to arbitrage option prices: too many factors are ignored BUT a powerful, simple toy model to: Understand which factors influence the price of an option and estimate its manufacturing cost Interpret a market quote (more on this in the next section)
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Black-Scholes in Practice
Implied Volatility
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Input/Output Diagram
Spot Price
Strike Price
Maturity Interest & Dividend Rates Volatility
Black Scholes
Option Price
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Implied Volatility Diagram
Spot Price
Strike Price
Maturity Interest & Dividend Rates Volatility
Black Scholes
Option Price
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Implied Volatility Example: S&P 500 Dec-08 options
Source: Bloomberg. Data as of 18 October 2006. 15
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Implied Volatility Example: S&P 500 Dec-08 options

Implied volatility 24% 22% 20% 18% 16% 14% 12% 800
Source: Dresdner Kleinwort. 16
1000
1200
1400
1600
1800
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Implied Volatility Smile and Term Structure

Implied Volatility Smile (or Skew) In Black-Scholes the volatility parameter is assumed to remain constant through time in practice every option expiring at time T has a different implied volatility depending on its strike K Implied Volatility Term Structure Also every option struck at level K has a different implied volatility depending on its expiry T.
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Implied Volatility Surface

smile
Implied volatility 24% 22% 20% 18% 16% 14% 12% 800 1000 1200 1400 1600 1800
implied volatility surface

60% 50% 40% 30%
+ term structure
ATM Implied volatility
=
1429 1348 1290 1198 1083 968 680 331
20% 10% 0%
Oct-07
Oct-08
Oct-09
Oct-10
Oct-11
18
2831
1970
20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Oct-06
1659
17-Nov-06 17-Oct-07 16-Oct-11
1544
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Reasons for Implied Volatility

In the early days options often had the same implied volatility. After the October 1987 crash, volatility surfaces appeared. Why? Stock prices do not follow the log-normal diffusion postulated by BlackScholes. Mainly: volatility is itself volatile, jumps can occur! In particular, stock prices and volatility are negatively correlated: when the market goes down, volatility goes up Delta-hedging cannot take place continuously, transaction costs can be significant. From a fundamental value perspective, implied volatility can be seen as a market adjustment to take into account everything which Black-Scholes does not. From a relative value perspective, implied volatility has become the standard measure to compare option prices, in a similar way as yield for bonds.
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Reasons for Implied Volatility: Evidence of Equity Skew

12 10 8 6 4 2
change in S&P 500 implied volatility
daily return
-8.00% -6.00% -4.00% -2.00% 0 0.00% -2 -4 -6 -8 -10 SPX Index linear regression 2.00% 4.00% 6.00% 8.00%
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Managing an Option Book

Greeks Hedging
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Definition of an Option Market-Maker

The job of an option market-maker is to provide liquidity to option buyers and sellers while securing her margin (bid-offer). Thus she will try to minimize the impact of market factors on the mark-to-market of her option book to make it as close as possible to a risk-free portfolio. Typical factors: Change in spot price: small & large Change in implied volatility Passage of time Change in interest rate Change in dividends.
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Greeks
The change in option price f resulting from a change in one factor is named sensitivity or Greek:
f S 2 f = 2 S f V= f = t f = r f = q =
Delta Gamma Vega Theta Rho Mu Change in f due to (small) change in spot price Second-order change in f due to (large) change in spot price = Change in due to change in spot price Change in f due to change in implied volatility Change in f due to passage of time Change in f due to change in interest rate Change in f due to change in dividends
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Greeks at Book Level

By linearity of differentiation, the Greeks of an option book are equal to the sum of the individual Greeks multiplied by the positions. For example: Book = Long 1,000 Option 1 and Short 500 Option 2 Book Value = 1,000 x Price 1 500 x Price 2 (mark-to-market) Book Delta = 1,000 x Delta 1 500 x Delta 2 Etc.
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Hedging
The standard approach to minimize the impact of market factors on the mark-tomarket of an option / a book of options is to offset (hedge) the Greeks with a relevant instrument Example: Delta-hedging Initial Book Delta = $5,000 per S&P 500 index point Delta-hedge = Sell 5,000 units of S&P 500 Final Book Delta = 0. This means that the book mark-to-market value is immune to (small) changes in the level of S&P 500.
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Hedging
To hedge other Greeks than Delta (e.g. Gamma, Vega) our market-maker must trade other instruments. However, it is usually impossible to perfectly hedge all Greeks. This implies that the market-maker is left with some risks. Her job is to design her option book so as to be left with the risks she is comfortable with (e.g. long Vega if she believes volatility is on the rise etc.).
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Trading Volatility
Where does volatility appear in Black-Scholes? Daily option P&L equation Volatility trading equation
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Trading Volatility
Definition
Taleb: Volatility is best defined as the amount of variability in the returns of a particular asset. [...] Actual volatility is the actual movement experienced by the market. It is often called historical, sometimes historical actual. Implied volatility is the volatility parameter derived from the option prices for a given maturity. Operators use the Black-Scholes-Merton formula (and its derivatives) as a benchmark. It is therefore customary to equate the option prices to their solution using the Black-Scholes-Merton method, even if one believes that it is inappropriate and faulty, rather than try to solve for a more advanced pricing formula.
Dynamic Hedging: Managing Vanilla and Exotic Options, John Wiley & Sons, 1997
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Trading Volatility
Definition
Historical (Realised) Volatility Annualized standard deviation of daily stock returns: Implied Volatility Volatility parameter in Black-Scholes model of stock prices (random walk / lognormal diffusion):
Historical =
where:
252 N (rt r ) 2 N 1 t =1
dS t = dt + Implied dWt St
S rt = ln t St 1
1 r= N
r
t =1
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Trading Volatility
Implied vs. Realised

True or False? An option market-maker sold a call at 30% implied volatility and delta-hedged her position daily until maturity. The realised volatility of the underlying was 27.5%. Her final P&L must be positive. False The trading P&L on a delta-hedged option position is path-dependent.
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Trading Volatility
Where does realised volatility appear in Black-Scholes?

Consider the Black-Scholes Partial Differential Equation:
f 1 2 2 2 f f rf = rS + S + S 2 S 2 t
With Greek notations:
1 rf = rS + 2 S 2 + 2
What is ? Realised or Implied?
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Trading Volatility
Where does realised volatility appear in Black-Scholes?

Remember that Black-Scholes derive the price of an option by modelling the behaviour of an option market-maker who follows a delta-hedging strategy. In this idealized world there is only one volatility:
Realised = Implied =
In reality traders tweak the model through the volatility parameter to make up for the model imperfections. As such they dont believe in the model, they merely use it.
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Trading Volatility
Daily option P&L equation

The daily P&L on an option position can be decomposed along the Greeks: Full Daily P&L = Delta P&L + Gamma P&L + Theta P&L + Vega P&L + Rho P&L + Mu P&L + Other Other = high-order sensitivities (e.g. sensitivity of Vega to a change in the spot price)
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Note that Delta P&L, Gamma P&L and Theta P&L correspond to the state variable risks modelled in Black-Scholes, while the Vega P&L, Rho P&L, Mu P&L etc. correspond to parametric risks which are not modelled in Black-Scholes. A more sophisticated model such as stochastic volatility with jumps would transfer some parametric risks (Vega) to the state variable risks universe, leading to different Greeks than Black-Scholes.
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Trading Volatility

Assuming constant volatility, zero rates and dividends, and Other is negligible, we obtain the reduced daily option P&L equation: Daily P&L = Delta P&L + Gamma P&L + Theta P&L = x (S) + x (S)2 + x (t) where S is the change in stock price and t is one trading day (1/252nd).
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Trading Volatility

For a delta-hedged option position, we have = 0. Hence: Daily P&L = x (S)2 + x (t) Typically Gamma and Theta have opposite signs: For a long call or put position, Gamma is positive and Theta is negative, i.e. the trader is long shocks/volatility (she makes money as the stock price moves) and short time (she loses money as maturity approaches.) For a short call or put position, the situation is reversed.
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Trading Volatility

Graph of Gamma vs. Theta
p/l at start of day p/l at close of business profit
loss
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Trading Volatility
Volatility trading equation

In fact, Theta can be expressed with Gamma through the proxy formula:
1 2 S 2 Implied 2
Plugging the proxy into the daily option P&L equation:
Daily P & L
1 2 (S ) 2 S 2 Implied t 2 2 1 2 S S Implied t 2 S
)
2
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Trading Volatility
Volatility trading equation

2 2 1 2 S Daily P & L S Implied t 2 S
This equation tells us that the daily option P&L on a delta-hedged option position is driven by two factors: Dollar Gamma, which has the role of a scaling factor and does not determine the sign of the P&L Variance Spread (realised vs. implied), which determines the sign of the P&L Thus, a trader who is long dollar gamma will make money if realised variance is higher than implied, break even if they are the same, and lose money if realised is below implied.
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The Second-Most Important Equation in finance according to Derman
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P&L path-dependency
Case study Path-dependency equation
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P&L path-dependency
Case study
An option market-maker sold a 1-year call struck at 110 on a stock trading at 100 for an implied volatility of 30%, and delta-hedged her position daily until maturity. The realised volatility of the underlying was 27.5% 2 months before maturity, her P&L was up 100,000 Yet her final trading P&L is down 60,000 How did the profits change into losses?
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P&L path-dependency
Case study
The hard life of an option trader...
Stock price 120 Strike = 110 100 80 60 40 20 0
Trading days
Cumulative P/L () 160,000 120,000 80,000
Stock price Cumulative P/L
40,000 -40,000 -80,000
14
28
42
56
70
84
98
112
126
140
154
168
182
196
210
224
238
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252
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P&L path-dependency
Case study
Realised Volatility and Dollar Gamma
Stock price
120 100 80 60 40 20 0
Trading days
Volatility
60% 50% 40% 40% 30% 20% 10%
Strike = 110
Stock price 50-day realized volatility

18% 29%
Dollar Gamma
0% 56 70 84 98 112 126 140 154 168 182 196 210 224 238 252
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Note that the graph of the dollar gamma actually corresponds to a short position.
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P&L path-dependency
Path-dependency equation
Summing all daily option trading P&Ls until maturity, we obtain the pathdependency equation:
2 Final P & L t rt 2 Implied t t =1 N
where t = x (t-1, St-1) x St-12 is the Dollar Gamma at the beginning of day t and rt = (St - St-1)/St-1 is the stock return at the end of day t. With this expression, we can clearly see that the final P&L is the sum of the daily Variance Spread weighted by the Dollar Gamma. Thus, days when Dollar Gamma is high will tend to dominate the final P&L.
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P&L path-dependency
A path-independent derivative?
For the final P&L to be path-independent (in the sense of the equation in the previous page), the Dollar Gamma must be constant. This defines a new type of derivative, the log-contract:
2 f c c t = c = 2 2 = 2 f = c ln S + bS + a S S S
Log-contracts are not traded, but they are closely connected to Variance Swaps introduced in the next section.
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Variance Swaps
Introduction Hedging & Pricing Mark-to-Market Valuation
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Variance Swaps
Introduction
A variance swap is an exotic derivative instrument where one party agrees to receive at maturity the squared realised volatility converted into dollars for a pre-agreed price:
where:
252 N S 2 2 t Variance Swap Payoff = $1 ln K var N t =1 S t 1 4 4 1 2 3 Squared log return
St is the closing price on day t N is the number of trading days between the trade date and the maturity date 252 is the number of trading days in a year Kvar is the variance strike expressed in volatility percentage points (e.g. 30%) and is not to be confused with the strike of a vanilla option which is a stock price level
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Variance Swaps
Introduction
Example Variance Buyer: Variance Seller: Underlying asset: Start date: Maturity date: Strike (Kvar): [Dresdner] [Sigma LLC] S&P 500 Today Today + 1yr 30% Payoff Calculation Scenario 1
Realised volatility 20% Payoff = $1 x (0.22 0.32) = $-0.05
Thus, the variance buyer (Dresdner) pays 5 cents to the variance seller (Sigma)
Scenario 2
Realised volatility 40% Payoff = $1 x (0.42 0.32) = $0.07
Here Dresdner receives 7 cents from Sigma
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Variance Swaps
Introduction
Note: Returns are computed on logarithmic basis rather than arithmetic The mean return is not subtracted (zero-mean assumption) In practice the log-returns are multiplied by 100 to convert from decimal to percentage point representation, and the variance strike is quoted in volatility points (30 for 30%) Often the number of variance swap units is calculated from a notional specified in volatility terms (e.g. $100,000 per volatility point):
Variance Notional =
Vega Notional 2 K var
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Variance Swaps
Introduction
Variance Swaps are actively traded on the major equity indices: S&P 500, Nasdaq, EuroStoxx50, Nikkei... Typical bid/offer spread is to 2 volatility points (vegas)
Indic. mids SPX NDX SX5E NKY Nov-05 15.6 16.7 17.4 17.5 Dec-05 15.2 16.6 17.0 17.5 Jan-06 15.3 17.4 16.9 17.4 Mar-06 15.7 17.9 17.5 17.2 Jun-06 16.2 18.9 17.7 17.6 Sep-06 16.6 19.8 18.0 17.8 Dec-06 16.9 20.4 18.6 18.1 Jun-07 17.4 21.3 18.7 18.6 Dec-07 17.8 21.9 19.3 19.2 Jun-08 18.3 22.3 19.6 19.7 Dec-08 18.7 22.6 19.9 20.1 Dec-09 19.6 23.1 20.3 20.4
Source: Dresdner Kleinwort. Data as of October 2005. 49
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Variance Swaps
Hedging & Pricing

Compare the Variance Swap payoff (1) with the P&L path-dependency equation (2):
252 N St 2 (1) Variance Swap Payoff = ln S K var N t =1 t 1

2 (2) Final Option P & L = t rt 2 Implied t t =1 N
Substantially, the difference between equations (1) and (2) lies in the weighting of the squared daily log-returns: Variance Swaps are equally weighted The final P&L of a delta-hedged vanilla option position is Dollar-Gammaweighted
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Variance Swaps
Hedging & Pricing

Thus, a Variance Swap could be hedged by an option with constant Dollar Gamma: the Log-Contract However, Log-Contracts do not trade in the market Problem: Can we find a combination of vanilla calls and puts with the same maturity as the variance swap such that the aggregate Dollar Gamma is constant? Formally: Find quantities (weights) w1Put, w2Put, ... and w1Call, w2Call, ... such that:
Aggregate = wiPut iPut + wiCall iCall = c

i =1 i =1
N Put
N Call
Put i struck at KiPut Call i struck at KiCall
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Variance Swaps
Hedging & Pricing

Answer: Use weights inversely proportional to the square of strike: wi = 1/Ki2
Dollar Gamma K = 25
Constant Gamma Region K = 50
K = 75
K = 100 K = 125K = 150
K = 175 K = 200
Aggregate
S 0 50 100 150 200 250 300
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Variance Swaps
Hedging & Pricing

A perfect hedge would require an infinite number of liquid options with strikes forming a continuum [0, ) The fair strike of a Variance Swap (i.e. the level of Kvar such that the swap has zero initial value) is then given as:
* var
+ 1 2e rT 1 1 = Put (k )dk + Call (k )dk 2 0 k 2 1 T k
where r is the constant interest rate, T is the maturity, Put(k), Call(k) denote the price of a put or call struck at k% of the underlying assets forward price.
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Variance Swaps
Mark-to-Market Valuation
Because variance is additive, the mark-to-market valuation of a variance swap position can be linearly decomposed between past (realised) variance and future (implied) variance:
T t t 2 Implied t2 K var MTM t = e r (T t ) Realized t2 + T T

where: Realisedt is the realised volatility between the start date 0 and date t (under zero-mean assumption) Impliedt is the current fair strike of a (notional) variance swap starting on date t and ending on date T Kvar is the strike level agreed on the start date 0
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References & Bibliography

My Life as a Quant, Emanuel Derman, Wiley (2004) Dynamic Hedging: Managing Vanilla and Exotic Options, Nassim Taleb, Wiley (1997) More Than You Ever Wanted To Know About Volatility Swaps, K. Demeterfi, E. Derman, M. Kamal, J. Zou, Goldman Sachs Quantitative Strategies (1999)
Self-referencing: Introduction to Variance Swaps, Wilmott Magazine (March 2006) Just What You Need To Know About Variance Swaps, with E. Strasser, R. Guichard, JPMorgan Equity Derivatives Report (2005)
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24 February 2007

Introduction to Volatility Trading and Variance Swaps

Volatility Trading and Variance Swaps

Typical Trading Floor Instruments

Exotics Futures Options

Volatility Trading and Variance Swaps

Typical Trading Floor Front Office

Trading Structurers Quants / Financial Engineers Research Marketing / Sales Economists

Volatility Trading and Variance Swaps

Volatility Trading and Variance Swaps

Key concepts behind Black-Scholes

Volatility Trading and Variance Swaps

Key concepts behind Black-Scholes

Why is Black-Scholes used in practice?

Volatility Trading and Variance Swaps

Key concepts behind Black-Scholes

Volatility Trading and Variance Swaps

Key concepts behind Black-Scholes

Volatility Trading and Variance Swaps

Key concepts behind Black-Scholes

Volatility Trading and Variance Swaps

Key concepts behind Black-Scholes

Volatility Trading and Variance Swaps

Key concepts behind Black-Scholes

Volatility Trading and Variance Swaps

Maturity Interest & Dividend Rates Volatility

Volatility Trading and Variance Swaps

Implied Volatility Diagram

Maturity Interest & Dividend Rates Volatility

Volatility Trading and Variance Swaps

Implied Volatility Example: S&P 500 Dec-08 options

Source: Bloomberg. Data as of 18 October 2006. 15

Volatility Trading and Variance Swaps

Implied Volatility Example: S&P 500 Dec-08 options

Volatility Trading and Variance Swaps

Implied Volatility Smile and Term Structure

Volatility Trading and Variance Swaps

Implied Volatility Surface

implied volatility surface

20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Oct-06

17-Nov-06 17-Oct-07 16-Oct-11

Volatility Trading and Variance Swaps

Reasons for Implied Volatility

Volatility Trading and Variance Swaps

Reasons for Implied Volatility: Evidence of Equity Skew

change in S&P 500 implied volatility

Managing an Option Book

Volatility Trading and Variance Swaps

Managing an Option Book

Definition of an Option Market-Maker

Volatility Trading and Variance Swaps

Managing an Option Book

Volatility Trading and Variance Swaps

Managing an Option Book

Greeks at Book Level

Volatility Trading and Variance Swaps

Managing an Option Book

Volatility Trading and Variance Swaps

Managing an Option Book

Volatility Trading and Variance Swaps

Volatility Trading and Variance Swaps

Volatility Trading and Variance Swaps