Condor Options

Lots of interest this weekend in the Striking Price article from Barron’s. You’ve got to like any article that begins with some colloquial German:

After so much sturm und drang in the global markets in 2007, investors increasingly will view volatility as an asset that can be traded, just like stocks and bonds.

The gist of the article is that when you’re making asset allocation choices, it isn’t enough to look just at the usual suspects of bonds, US equities, global equities, commodities, etc. Volatility itself, say the authors of a research paper just out from Goldman Sachs, should be treated as an asset class deserving of its own allocation. (Incidentally, do any of you have access to this paper?)

That basic thesis is hard to argue with, although it may not be as unusual or remarkable as it first appears. After all, every position involving options is going to have some kind of vega value, so even the most timid covered call player is actually already taking a position regarding volatility, however unintentionally.

I suppose the very notion of trading volatility on purpose is the innovative bit. But that’s where things get a little tricky.

One problem in viewing volatility as an asset class is that it’s hard to model; data is scarce beyond the Chicago Board Options Exchange’s Market Volatility Index (VIX).

Well that’s not quite true. The VIX tracks the S&P 500, but there are also volatility indexes for the Russell 2000 (RVX), the Nasdaq 100 (VXN), the Dow (VXD), the good old S&P 100 (VXO), and of course the new 3-month S&P 500 (VXV). There are futures available on some of those indexes, and as of September 2007 there are now also options on RVX and VXN. The CBOE has a nice overview page about all this. The point is that while you still have to do some digging, it’s not like we’re flying blind here in terms of volatility data. Total volatility geeks will want to check out the paper on the CBOE’s S&P 500 Volatility Arbitrage Strategy Benchmark.

But I digress. The real problem isn’t a lack of volatility data; it’s knowing how to trade volatility. And this is where the authors say some weird stuff, like:

Anyone with a basic understanding of options can benefit from volatility… Put selling and strangles selling beat call selling against stock, a strategy that has emerged as a mainstay in the options market.

Adam already beat this one down sufficiently, so I’m not going to duplicate the effort.

How to Trade Volatility?

But besides the fact that selling naked puts is identical to selling covered calls, it’s not at all true that it only takes a “basic understanding of options” to benefit from volatility. For one thing, it’s not like you can just dial up a Volatility ETF on your E*Trade platform and go to town. And even if there were an ETF that tracked, say, the VIX, you’d have to be a little nuts to want to trade the VIX like a stock.

Another possible way of trading volatility is the use of VIX/RVX/VXN options. This is not for the faint of heart, and there are very few successful VIX option cowboys around, as far as I’m aware. Options on these indexes don’t behave like normal options for several reasons (not going into that here).

Of course the real way to trade volatility is to remember that implied volatility is always implied about something: a stock, an index, front-month at the money options on an index, something. So the best idea is just to trade vega-negative options strategies on any major index. There are plenty of ways to do that, so it’s a little strange that the Goldman Sachs report recommends put selling and strangle selling as the way to go. Put selling just equals covered call selling, which everybody and his brother already does, and it’s not clear to me that a simple straddle- or strangle-selling strategy is appropriate or even desirable for most investors (remember, this Goldman report is advocating the widespread trading of volatility as such).

Reducing Risk, Increasing Complexity

So on the one hand, suggesting that average Joe money managers should start throwing multi-legged short IV positions into their portfolios makes some academic sense; on the other hand, it’s a recipe for widespread structural problems and general grief!

I realize that that’s a big claim. Here’s what I mean: presumably the purpose of Goldman recommending a perpetual volatility short is that traders can scoop up bits of premium every month in exchange for providing extra liquidity. But there’s a danger here if each trading desk and vanilla fund manager and retail trader now putting on pure IV positions thinks that he or she is reducing portfolio risk by adding this new “asset class”. As a matter of fact, he’s probably increased his risk significantly. The next time a major event moves the markets downward, those short puts and short strangles will start hurting really fast, both because there are obviously still some deltas at work in those positions, but also because when the IV spikes those positions will be worth a lot more even if the underlying doesn’t move all that much.

Adding a short volatility component to mainstream investor portfolios, could conceivably have the effect of magnifying large and unexpected market moves (rather than smoothing out portfolio returns), and, not to get all apocalyptic about it, but could even intensify the vicious cycles and feedback loops that are so common during major market panics.  This happened in the bond markets during the LTCM crisis in 1998: increased complexity and unacknowledged risk meant that when LTCM had to cover some of its positions as a result of the Russian default, its own selling pushed prices down and triggered a death spiral of fleeing liquidity, such that each round of selling at lower prices triggered greater risk warnings, requiring even more covering.  The same thing could happen in equities: if every fund manager and his brother gets short volatility as a matter of course, when the next panic situation hits, those positions will only add to the selling pressure.

This is admittedly hyperbolic and speculative on my part.  But the basic point is pretty clear: until there are both highly liquid and well-constructed vehicles for trading volatility, and widely adopted and adequate risk control measures for analyzing the impact of volatility trading, the concept of volatility as its own asset class is an idea whose time has not yet come.

[tags] volatility, risk, VIX, RVX, VXN, vega, Goldman Sachs, LTCM [/tags]