When faced with a threat to their portfolios, most institutions try to hedge out the threat as a primary line of defence. That reaction suits volatility managers just fine: hedging strategies bring a nice transaction flow, carrying regular pricing inefficiencies, into this uncrowded corner of the options universe. SIMON MUMME reports.

The near future will not be as tumultuous as most of us believe – this has been the experience of recorded market history to date, at least. Investors’ fears of the future have generally been more menacing than what has eventually transpired. And when those scared investors buy options to hedge out some of the threats to their portfolios, they pay nice premiums to their risk-taking counterparts. In the options universe, as in others, fear creates pricing inefficiencies, and profiting from fear is what volatility trading is about.

When an investor buys an option, their expectations of future volatility are reflected in the price they pay. This implied volatility often reverts to its historical mean, and the price of the option usually follows. That investors pay too much for protection presents a major inefficiency for volatility traders to exploit: implied volatility is almost always greater than actual volatility, providing shorting opportunities amongst other arbitrages. For Al Wilkinson, portfolio manager of the Pengana global volatility fund, investor fear is a tradeable commodity.

“Every financial decision that an investor makes has a volatility component. How do you value a security? How much risk do you want to take? Those measurements have been quantified and are tradeable in a number of contexts,” he says. “The idea of volatility is made once you get a price.” Wilkinson, a former director of the Chicago Boards Options Exchange (CBOE), led the team at that bourse which created the Volatility Index (VIX), also know as the ‘fear index’, which tracks the market’s expectation of 30-day volatility as conveyed by the prices of options derived from the S&P500 index (“I’m the father of the VIX,” he says). Most of the trades made for the Pengana fund are conducted through this exchange. Wilkinson says it’s the volatility of S&P500 options – not the trend of the underlying index – that makes the institution a marketplace.

“You’re not trading the direction of the S&P500 – you’re trading the volatility component.” The pain incurred by global markets during the credit crunch has seen option prices in the VIX reach levels higher than 42 and as low as 17, near its long-term average. On September 18, it posted a six-year high of 42.16. In the past 10 years, it has closed higher than 42 on two other occasions only: following the September 11, 2001, terrorist attacks on New York and in September 1998, in the aftermath of the Russian debt default and collapse of hedge fund Long Term Capital Management. In more moderate times, the VIX moves between 15 and 18.

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