Risk Latte - Volatility Trading Using Vanilla Options

Volatility Trading Using Vanilla Options

Team Latte
Mar 14, 2006

There are three major kinds of volatility trades, conventionally speaking, which can be executed using vanilla options.

1.   First Order Volatility Trade : This is achieved through buying (long) and selling (short) of straddles, i.e. long straddles (a long straddle is buying a call option and simultaneously buying a put option with the same strike), short straddles, long and short strangles, etc. In a first order volatility trade all options are either long or short. These trades have the characteristics that though the gamma changes over time, the trades are monotonically long or short vol and the vegas and the gammas are on the same side of the market (both are positive or both are negative); For example: a long straddle on Nikkei225 futures options is a first order vol trade whereby the trader expects the Nikkei225 vols to be rising; or a short strangle on Gold futures options is a first order vol trade whereby the trader expects the gold volatility to drop

2.   Second Order Volatility Trade : A second order volatility trade is achieved by going long and short options at the same time by combining different strikes and maturities but within the confines of one product. A call spread whereby by the trader is long 104 calls and short 108 calls in equal amounts on a particular product is a second order volatility trade. A defining characteristics of these trades is that the gamma and the modified vega (not the raw vega) always reverses sign (from positive to negative) somewhere along the surface. A 3 month long call on Dollar-Yen at 115 and a six month short call on Dollar-Yen at 121 is a second order volatility trade.

3.   Fourth Moment Volatility Bet : A fourth moment volatility bet is long or short vvol (volatility of volatility). Calendars or reverse spreads are generally used to achieve fourth moment bets. If a trader buys large amounts of out of the money SP 500 futures options and finances these purchases by selling small amounts of at the money SP500 futures options such that the trade generates a positive cash flow then he takes a fourth moment bet, i.e he is betting on the vvol of SP500 futures.

Though these days there are a lot of new and complex products such as exotics and variance swaps to trade volatility, conventional volatility trading using vanilla options still remains one of the very popular methods of trading volatility amongst dealers and prop traders (if anyone is a true prop trader anymore) and yes, the hedge fund manager.

Note : Practitioners interested in learning more about volatility trading should read Nassim Taleb's work. There is no one more accomplished in the field of option trading than Taleb and newcomers to this field will find no greater teacher than Taleb.


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