Download - Equity Volatility: Managing and Profiting
Equity Volatility:Managing and Profiting
Greg LevinsonChief Investment Officer
Schooner Investment Group FPA Meeting July 21, 2010
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Volatility Basics
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Just Kidding!!
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Goal for this Presentation
If you can't explain it simply, you don't understand it well enough.
- Albert Einstein
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Greg Levinson
• Wharton School, University of Pennsylvania, 1995.• Former Managing Director BNP/Paribas – Cooper
Neff.• Founder and Former Managing Member, Polaris
Advisors LP.• Founder and Managing Member, Schooner
Investment Group.
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About Schooner
• Radnor, Pa Based RIA.• Boutique Specialty Manager focusing on equity
volatility strategies.• Core Investment team has worked together over 15
years.• Formed in January 2008 to offer team’s investment
expertise in liquid and transparent vehicles. • Institutional Investment Manager Only.– Advisor to 40Act Mutual Fund.– Sub-advisor for other Advisors.
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Defining Volatility
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Defining Volatility
• Variation from the average value over a measurement period. (standard deviation)
• Volatility does not equal Risk.– Volatility is just one quantitative metric of risk.– Risk is a concept.– Volatility can create opportunity.
• MPT and Efficient Frontier: rely upon standard deviation as the singular metric of risk.
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Approximations of Volatility
• It can be approximated by saying that if the volatility is calculated by the standard deviation of the asset prices.
• Then approximately 2/3 of the time the price will be within one standard deviation of the average price over time.
• Measurement period is important.• Mean and SD quoted as an annualized number:
Daily Vol = σ / ______________________________________________________________________________________________________________________________________________SCHOONER Investments
t
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Normal Curve Distribution
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Historical Realized Volatility • Calculated by measuring the asset’s past price
movements.
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Future Forecast Volatility
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Future Forecast Volatility
• Forward volatility can never be known, because the time frame is the future.
• Estimate is based upon more than the volatility history of the asset.
• Takes into consideration any events that are known to be occurring during forecast period.
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Implied Volatility
• Unlike other types of volatility, this is a property of the option (rather than of the asset).
• Estimate, made by professional traders in the marketplace, of the future volatility of the asset.
• The volatility, that when substituted into the equation used to calculate theoretical values, makes the theoretical value equal to the actual price of the option in the marketplace.
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Volatility Price Example
• SPY current price = 100• If the price of 30 day, 100 strike puts or calls = $1• Then implied volatility is 10• Security Bullish / Vol Buyer : Buy Calls• Security Bearish / Vol Buyer : Buy Puts
• If the price of 30 day, 100 strike puts or calls = $4• Then implied volatility is 35• Security Bullish / Vol Seller : Sell Puts• Security Bearish / Vol Seller : Sell Calls
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What is the VIX?
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What Does VIX - CBOE Volatility Index Mean?
• Index which shows the options market’s expectation of 30-day volatility.
• Constructed using the implied volatilities of a wide range of S&P 500 index options.
• Intended to be forward looking and is calculated using both calls and puts.
• VIX considered to be premier barometer of investor sentiment and market volatility.
• VIX is a calculated index, not a security.
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VIX closing levels since introduction
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VIX = “FEAR INDEX”
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VIX = “FEAR INDEX”
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Put/Call Parity
• PUT = CALL – STOCK + PV(STRIKE)• A Put can be replicated by buying a call and selling
the stock short; A call can be replicated by buying a put and buying stock.
• When current stock price and strike are the same, then the price of the put equals the price of the call.
• Any violation allows for riskless arbitrage opportunities.
• The price of puts affects the price of calls, and vice versa.
• Example is for illustrative purpose and assume options in simplest form: European exercise, no dividends, flat borrow/lending rates, no shorting restrictions/costs
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Put/ Call Parity Example
• Stock at 100 • 100 strike call = $2 ; 100 strike put = $3• $1 Arbitrage exists buying call, selling put and
shorting stock.
If at maturity stock is $80, then make $20 selling stock short, lose $17 from selling put, and lose $2 from worthless call expiration for total $1 profit.
If at maturity stock is $120, then lose $20 selling stock short, Make $18 from purchasing call, and make $3 from worthless put expiration for total $1 profit.
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Paradox of Vol
• When investors are concerned about declining prices. • Their fear leads them to pay higher prices for puts.• Which leads to higher prices for calls.• Which are bullish options.
• Ergo, when investors are concerned about declining prices, the price of bullish options also goes up, because of Put/Call Parity.
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Basic Hedging Strategies for Equities
• Buying Puts
• Selling covered calls
• Collars
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UNHEDGED
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Buying Protective Puts• Provides downside protection.• Long volatility strategy.• Best to buy insurance BEFORE the threat is on
doorstep.
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Selling Covered Calls
• Collect premium for selling some upside beyond a predetermined level.
• Yield generator.• Short volatility strategy.
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Collars
• Simultaneous sale of call and purchase of put on same underlying.
• Predefines both maximum gain and maximum loss on underlying.
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Volatility as an Asset Class
• Changes in the “price of volatility” can be used as standalone or complimentary investment strategy.
• Employ strategies to take advantage of varying volatility environments and fluctuations in the pricing of implied volatility.
• Volatility allocation in a portfolio can lead to higher alpha, lower beta, and superior risk return profile in both bull and bear markets.
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Core Volatility Based Trading Strategies
Basic
• Buy - Writes (covered calls)• Convertibles
Advanced
• Correlation and dispersion trading• Variance swaps
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Covered Calls
• Can be used portfolio wide on large baskets of core equity holdings.
• Premium collected buffers losses from any declines in underlying equity positions.
• Allows investor to retain upside exposure to equity holdings• Requires very disciplined investment strategy and trading
expertise.• Must decouple volatility assessment from directional
assessment.• Often self initiated by retail investors with disappointing
results.
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Convertible Bond Basics
• Fixed income instruments that have coupons lower than non convertible bonds of same issuer.
• Holder has the right to exchange the bond into a specified number of shares of the underlying stock.
• “Orphaned” and low profile hybrid asset class often overlooked by investors.
• Most attractive during periods of credit stability and low / rising equity volatility.
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Convertible Price Behavior
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Volatility Arbitrage
• Trading of index volatility against constituent single name volatility.
• Index implied vol is function of underlying securities individual volatilities and correlations.
• Index implied volatility < mean constituent implied volatility.
• Core bet is on correlation. • Correlation typically ranges between .5 and .7 for
SPX• Correlation spikes during times of distress.
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Implied Volatility Correlation
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Variance Swaps
• Over the Counter statistical bets.
• Used by Hedge funds and Bank Prop desk.
• Compares the actual close to close daily variance vs. the trade “price”.
• Difference is paid at maturity to “winning party”.
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Why Invest in Volatility
• Correlation between many traditional asset classes is historically positive.
• Long recognized and observed that during periods of market declines and stress, correlations tend to go to 1.
• When assets correlate highly, the risk reduction benefits from holding a portfolio of diverse asset classes is materially reduced.
• “Price of volatility” has negative correlation with equity markets and other risk assets.
• Unsustainably high volatility pricing during times of distress creates opportunities to “counter punch” against investors driven by fear.
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How to Invest in Volatility
• VIX based ETFs
• Hedge Funds
• Mutual Funds
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VIX based ETNs
• VXX is an ETN that offers exposure to a long position in the first and second month VIX FUTURES contracts.
• High liquidity makes it a good short term trading vehicle.• Shape of the futures curve has deep impact on ETN
performance. • While correlation between VIX and VXX is high,
performance of VXX suffers due to contango and roll risk.• Lousy long term investment…. “It’s a bleeder”.• Buyer beware.
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VXX “bleed”
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Hedge Funds• Pros
• Can go anywhere and trade anything, pioneers.• Sophisticated strategies and generally high
talent.
• Cons
• Poor liquidity and lack of transparency.• No regulation.• Possible high leverage.• Expensive.• High minimums.
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Mutual Funds
• Pros• Daily liquidity and transparency.• Regulated.• Retail friendly.
• Cons• Limited experience in sophisticated strategies.• Restrictive mandate or expertise.
• Covered call only• Convertible only
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What Do Investors Need?
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What Do Investors Need?
• Dampened volatility.• Participation in equity market upside. • Removal of catastrophic left tail risk.• Exposure to volatility as an asset class.• Liquidity.
One solution is in the packs in front of you. Thank You.
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