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Given the market turmoil of late I have become fixated with this idea of using options to be long volatility (realised and implied). However, I dont know where to start, what to read, who to follow etc to actually understand how this is done in practice.

For instance, what strategies do traders use to execute a long vol strategy (presumably it is not as simple as buying a put or buying a call)?

And how does one go about delta hedging a portfolio of options which are long vol?

Does anyone have any ideas?

Appreciate the help on this

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  • $\begingroup$ direct message me as well for people who are not comfortable posting up here. Need all the help I can get. Cheers $\endgroup$
    – AShortSqueeze
    Commented Mar 29, 2020 at 0:05
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    $\begingroup$ There is no direct messaging here, and it's selfish for you to ask for it. The point of this community is for answers to help future readers, not just you. $\endgroup$
    – Joseph Sible-Reinstate Monica
    Commented Mar 29, 2020 at 19:20

3 Answers 3

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The simplest long vol strategy is to be long an ATM straddle and delta hedge it, the problem is that when it is no longer ATM the exposure to vol weakens. You could then sell that straddle and enter another ATM one.

Another solution is the vol swap or variance swap mentioned by Stephane below. It gives constant exposure no matter what the level of S&P. But be careful: var swap gives you exposure to squared vol so huge P&L when vol spikes (many vol traders and institutions were recently taken to the cleaners if short). Also they have some other drawbacks that Stephane mentioned.

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    $\begingroup$ We'd have to factor in two things here. First, those swpas trade OTC and it's not crazy to think realistic transactions costs will fall in the 1-2% range (I take those figures from Giglio and Kelly, 2018). Index options are exchange traded and pretty liquid, but you'd need a few of them. Given that Carr and Wu (2014) proxied their continuum of strikes pretty well with just 5 strikes, I suspect you're looking in pratice at a pretty small basket here too and it might be better to make the portfolio yourself. Second, those swaps are polluted by exposure to higher moments. $\endgroup$
    – Stéphane
    Commented Mar 29, 2020 at 15:42
  • $\begingroup$ Yes, thank you. Very good points. $\endgroup$
    – nbbo2
    Commented Mar 29, 2020 at 16:36
  • $\begingroup$ thanks for the feedback noob2. Could you point me to a reference/book which goes into other long vol strategies? The reason I ask is that perhaps I just need an options book which goes into different types of option set ups/strategies and pick and choose what works - any ideas? $\endgroup$
    – AShortSqueeze
    Commented Mar 30, 2020 at 0:36
  • $\begingroup$ also noob2 just to clarify. You mention specifically an ATM straddle strategy, this is because the vega of the option is greatest at the money and starts to decrease once you move away from the strike up or down, yes? $\endgroup$
    – AShortSqueeze
    Commented Mar 30, 2020 at 0:42
  • $\begingroup$ Yes, the Vega of a straddle is highest when the strike is ATFM (K = F, where F is the forward price), I said ATM (i.e K=S) which is not strictly right but close, I should have said ATFM, sorry. The only book I have which covers vol trading is the Euan Sinclair book mentioned earlier. It is from 2013, so not the latest. There is also Volatility Modeling by Lorenzo Bergomi, but very advanced, I haven't tackled it yet, it may be beyond my level. $\endgroup$
    – nbbo2
    Commented Mar 30, 2020 at 13:52
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What not to do

What you are asking us, without knowing, is related to how to price a variance swap. Well, under a general diffusion process, variance swaps can be priced by forming a suitably weighted portfolio of options over a continuum of strike prices with the entire portfolio maturing on a given date. The intuition is that your exposure to volatility changes when the the spot price of the underlying changes for one option: in financial parlance, your vega is a function of the spot price. But for a pure volatility exposure, you'd like to get rid of that dependance.

The unfortunate thing is that if you move toward a model that admits conditional nonnormality in returns (in continuous time, a jump-diffusion model would do just that), you're demonstrably incapable of pricing variance swaps: you don't have a strategy that allows you to build pure exposure to volatility because quadratic variation is going to be polluted by higher moments (see Martin (2017) for details). I mention this obvious problem in case someone

What to do

On the other hand, there is something you can do which is valid, even under the general context of jump-diffusions. Variance swaps focus on the observed quadratic variation in the growth rate of log prices, so they're always polluted by higher order term. Martin introduced the idea of simple variance swaps (their payoff depend on squared price changes, weighted by squared futures prices) to build a new index. As it happens, just like the VIX is built by discretizing the integrals used in the pricing of variance swaps, his index is also built from a portfolio of European options on the S\&P500...

All you have to do, if you want to "go long volatility" is to look up Martin (2017), find the integral defining his index (the SVIX) and discretize it. You have a portfolio of options, just not weighed the same way as in the VIX. To determine how many options you need in practice, pick a few jump-diffusion models, run simulations and see how many options you need to get precise results. That method absolutely will give you exactly what you need to know to be long vega in as general a context as can be -- you know, outside stable processes where what you're asking wouldn't make any sense.

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    $\begingroup$ Thanks stephane. When you refer to martin (2017) are you referring to his paper in the quarterly journal of economics: “what is the expected return on the market”? $\endgroup$
    – AShortSqueeze
    Commented Mar 29, 2020 at 6:47
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    $\begingroup$ Yes, I am refering to this paper. Also note that the strategy implicit in his construction of the SVIX relies on a static replication argument, so you take your position once. $\endgroup$
    – Stéphane
    Commented Mar 29, 2020 at 15:20
  • $\begingroup$ i'll have a look at it, but looks like variance swaps are not exchange traded which is an issue for me. Still looks interesting though $\endgroup$
    – AShortSqueeze
    Commented Mar 30, 2020 at 0:30
  • $\begingroup$ @Choco93, I think I might have lost you above. Martin's SVIX is an index computed very much like the VIX using a portfolio of European options on the S&P500, except that he uses slightly different weights. In essence, if you want to go long volatility, just look at what portfolio he uses to compute his SVIX and BUY THAT. This is a PURE volatility exposure based on static replication so you don't have to worry about rebalancing. $\endgroup$
    – Stéphane
    Commented Mar 30, 2020 at 15:39
  • $\begingroup$ Thanks Stephane I'll have a closer look $\endgroup$
    – AShortSqueeze
    Commented Mar 31, 2020 at 4:16
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I do not mean to discourage you, but it sounds like you're a wee bit late for this round of volatility games, for two reasons:

  1. You are still trying to figure out how to implement a long vol strategy.
  2. The market has already priced the risk in, i.e. buying volatility is already expensive.

However, never too late to learn and prepare for a next time. My suggestion would be first learn what delta hedging a single option really is. Explore delta hedging under Black-Scholes, then what happens if the world does not follow Black-Scholes but you do, and so forth.

Once you understand the basics of Black-Scholes and you are specifically looking at vol trading, then Euan Sinclair's book is a good place to start:

Euan Sinclair, Volatility Trading

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  • $\begingroup$ ilovevolatility: well aware of 1 and 2 but currently just dipping my toes in the water. As for your comment on delta hedging in a black-scholes world and delta hedging using black-scholes in a not so black-scholes world (ie reality) - do you have any suggestions on what I should read (or do) here? I studied derivs back at university so I know black-scholes and delta hedging but from a very theoretical perspective. Any ideas on how I could get a feel for how this is implemented in practice? $\endgroup$
    – AShortSqueeze
    Commented Mar 30, 2020 at 0:54

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