Hedge funds are increasingly looking to volatility strategies in order to extract value and performance across-asset classes, according to panellists at the Index Derivatives and Volatility Research Seminar which took place on June 11 at the London Stock Exchange (LSE). This is the first of two articles, with the second appearing tomorrow.
Volatility has been accepted as an asset class and futures, options and exchange-traded products (ETPs) remain as the preferred instruments used by alternative funds targeting volatility, according to the panellists. “We do trade in options and take positions on volatility by writing options in different markets, different strikes, different times of the term structure, and different parts of the skew,” said John Moffat, manager, world index book at Capstone. “Trading standalone, out-of-the-money volatility is still there, but we believe that, if you can bring different parts of the term structure and the skew, that’s when then you can take advantage of opportunities.”
Traders have gone beyond equity volatility and are trading volatility more actively in other asset classes, such as fixed-income (bond futures) and foreign exchange, according to Jean Francois Bacmann, head of volatility strategies at Man AHL. “You can definitely find a lot of liquidity in listed options, but we are also very active in trading warrant swaps on the OTC side,” said Bacmann. “Our focus is on building systematic strategies and in this context it is very important to trade the instruments (option or warrants) that fit with the strategy rather than with the market specificities.”
The panel agreed that the use of volatility underlyings, such as the CBOE Vix Index, has changed and this family of indices are now being used beyond the alternative asset management market as they are seen as appropriate benchmarks for more traditional managers. In the structured products market, the CBOE’s Vix index has seen increasing traction since 2011 and has been featured in more than 360 products, mainly leverage/turbo certificates issued in Germany, the Netherlands/Belgium, and France. “The trading of volatility products has been used traditionally to take efficient positions in markets and was used mainly by specialist option traders, but the granularity of these underlyings enables them to be used more widely to diversify strategies,” said Barry Feldman, senior research analyst at Russell Indexes.
The trading approach from hedge fund managers has changed over the last five years on the back of changes around markets and models, according to James Lubin, senior managing director at CBOE Futures Exchange.
Over the last few years, banks have not been willing to take on risk in the equity derivatives market and have generally tried to offset risk from their books and sell volatility, resulting on an increase in volatility supply. The increase in size of the structured products markets in Asia and in Europe around enhanced yield products has had a significant impact on the way volatility trades, according to Moffat. “Autocallable products issued in Asia used to be focused largely on the Asian market (using Asian underlyings) and sold to Asian retail investors,” said Moffat. “But we are starting to see this kind of products being issued in the US market and Europe, and this is driving the way the volatility market works in the listed options market which is quite different from what it used to be a few years ago.”
Traditionally, said Moffat, there was great demand for downside protection in Europe and the US, with traders looking to write put options. “That is not happening as much at the moment and that’s a reflection of the risk on bank’s books and traders are not willing to take the other side of the flow they’re getting from some of these products,” he said.
From a trading perspective, traders are in a better situation. “In the short-term this became challenging because we had to operate in markets that were quite different from what they used to be,” said Moffat. “But in the long run, the bigger the dislocation the better. Options are way cheaper than they use to be five or six years ago and this has created opportunities around volatility strategies,” he said. “This is a consequence of structured products coming through in the listed market.”