Selling volatility has been a popular trading strategy among hedge funds over the past couple of years. At the core of the strategy’s popularity is the observation that volatility becomes considerably more severe when the markets are moving down rather than when they are rising up (see, for example, “The Cross-Section of Volatility and Expected Returns” by Ang, Hodrick, Xing and Zhang, Journal of Finance, 2005). In other words, selling volatility is a complicated way of betting on the rise of the market.
During the current administration’s tenure, the U.S. markets have consistently risen, while dampening volatility in the process and generating excitement among the volatility-selling set. The strategy of selling volatility (“vol”), however, is full of hidden and not-so-hidden surprises, and is not for the faint-hearted. This article examines the strategy’s implementation and pitfalls.
Selling volatility can take many forms. The most common is using options. These are relatively short-term publicly-traded instruments that allow explicit betting on the direction of the market. A popular, somewhat protected or “hedged” vol-selling strategy involves selling call options on the U.S. volatility index, such as VIX or its traded ETF counterpart VXX, at the higher price and buying calls on the same instrument at the lower price. A call option on VXX is a traded right to buy VXX at a pre-specified “strike” price on or before a certain “exercise” date. Both call options traded in the vol-selling strategy should have the same expiration date in order to hedge the time value of the option, known as “theta”. The more expensive call option is typically the one with a lower strike price, and the less expensive one is the one with the higher strike price.
A specific vol-selling strategy on July 28, 2018, therefore, may look like this: buy a September 21 call option on VXX with strike of $33.00 for $3.04 per contract ($304 total) and simultaneously sell a September 21 call option on VXX with a $32.00 strike for $3.35 ($335 total). If the volatility stays constant or declines through September 21, the strategy results in a $21 profit minus small transaction costs.
If volatility declines and VXX decline, both sets of calls may expire worthless, letting the trader realize the difference between the higher and the lower values. What happens, however, when volatility rises? How often and how bad can that be?
To answer this question, we can study the behavior of the VIX index, a widely accepted readily-available metric of U.S. market volatility. Figure 1 charts VIX index values over time from September 2014 through June 2018 (the VIX data is from Yahoo! Finance). As the Figure shows, high spikes in VIX are quite common and arrive without much warning. Specifically, in the 946 days from 9/2014 through 6/2018, VIX index rose 5% or more from one day’s close to another 60 times. That, on average, translates to a volatility rise of 5% once every 3 weeks, or over 6% of time. After each spike, the volatility takes a while to die down.
Should volatility rise, however, the trader is potentially liable to the difference in strike prices at option expiration. Thus, if on September 21, VXX is at $33.00 or above, the strategy owner is obligated to sell VXX at $33 per share for 100 shares, but can offset his losses at $32 per share, thus losing $100 — still a loss five times greater than the possible gain.
Figure 1. U.S. Market volatility, as measured by the VIX index, from September 2014 through June 2018.
How can one sell volatility, but profitably? The answer lies in an unlikely source of volatility itself: aggressive high-frequency traders, or AHFT. As discussed in Real-Time Risk: What Investors Should Know About Fintech, High-Frequency Trading and Flash Crashes (Aldridge & Krawciw, Wiley, 2017) and High-Frequency Trading: A Practical Guide to Algorithmic Systems and Trading Strategies (Aldridge, Wiley, 2013), high-frequency trading appears to cause volatility. As such, tracing aggressive HFT behavior in a U.S. market index, such as SPY, on a daily or more frequent basis becomes a leading indicator of impending changes in volatility. AbleMarkets has taken this research and developed the aggressive HFT Index. The daily version of the aggressive HFT Index for single stocks, ETFs, currency pairs and commodity futures is presently available at AbleMarkets.com for just $35 per month (prices may change, see http://ablemarkets.com/platform/2018/03/23/aggressive-hft-index/).
Specifically, it is the discrepancy between the buyer-initiated and the seller-initiated aggressive HFT activity that makes a difference for volatility prediction. When aggressive HFT appears to buy more SPY than sell in a given day, the volatility as measured by VIX tends to go up the following day, and vice versa. A strategy trading vol with the AbleMarkets Daily Aggressive HFT Index can be as simple and as powerful as this:
- If the AbleMarkets Daily Aggressive HFT Index for SPY shows that Aggressive HFT Buyers exceeded Aggressive HFT Sellers on any day i, buy volatility at close of day i.
- If the AbleMarkets Daily Aggressive HFT Index for SPY shows that Aggressive HFT Sellers outnumbered Aggressive HFT Sellers on any day i, sell volatility at close of day i.
Figure 2 illustrates performance of the AHFT-enabled volatility trading versus pure volatility selling over the 2014-2018 period. The strategy returns can be enhanced dramatically via options strategy discussed above.
Figure 2. Strategy performance comparison: selling VIX and trading VIX according to the AbleMarkets Daily Aggressive HFT Index for SPY, 2014-2018.
Irene Aldridge is Managing Director, AbleMarkets, and Visiting Professor, Cornell University. She is a co-author of Real-Time Risk: What Investors Should Know About Fintech, High-Frequency Trading and Flash Crashes (Aldridge & Krawciw, Wiley, 2017)and author of High-Frequency Trading: A Practical Guide to Algorithmic Systems and Trading Strategies (Aldridge, Wiley, 2013). She can be reached by email at firstname.lastname@example.org