Trading Volatility In Volatile Times

Today, volatility can be traded like any other asset. VIX linked Exchange Traded Products (ETPs) and their underlying futures have become some of the most liquid instruments traded in the United States – almost $1bn a day of the popular Barclays iPath Series B S&P 500 VIX Short Term Futures ETN (VXX) trade each day for example. But unlike simpler assets, volatility and the products that are derived from them, are far more difficult to price.

Rigorous attempts at valuing volatility products stretches back almost 50 years with the publication in 1973 of ‘The Pricing of Options and Corporate Liabilities’ by Fischer Black and Myron Scholes and the model we now call the Black–Scholes options pricing model.

But a lot has changed in those 50 years. From a simple model to systematically value put and call options, today we rely on a series of complex models that Dr. Emanuel Derman described earlier this month as allowing ‘…traders to treat the volatility parameter in the model as an asset and trade it..’ here. I couldn’t agree more.

Most volatility traders will be familiar with Emanuel’s work. A fellow South African and Alumnus of the University of Cape Town, he is now a professor of finance at Colombia University and has over the last 30 years developed and transformed our understanding of volatility from a mathematical curiosity to a growing asset class. Emanuel is credited together with Iraj Kani, for example, with introducing the world to the concept of ‘Volatility Smile’ in 1994 in their paper ‘The Volatility Smile and Its Implied Tree’ here. Since then, volatility ‘Smile’ and ‘Skew’ have been central in valuing volatility-based products.

Put simply, the Black–Scholes options pricing model ‘assumes that a stock's future return volatility is constant, independent of the strike and time to expiration of any option on that stock.’ Emanuel observed that this was how implied volatilities were modeled before the stock market crash of 1987. After that everything changed.

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This article is not intended as, and does not constitute, investment advice. Investing involves risk, including the possible loss of principal. Past performance does not guarantee future results. All ...

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Dean Gilmore 1 month ago Member's comment

Right on the money.