Quantitative Strategies for Trading Volatility

Bruno Dupire Head of Quantitative Research Bloomberg L.P.

CBOE Dublin, September 7, 2012

Known Unknowns

I know one thing, that I know nothing. Plato

Known Unknowns
There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns there are things we do not know we don't know. United States Secretary of Defense Donald Rumsfeld

Known Unknowns
I know very accurately how much I do not know. VIX market

OUTLINE
I. Frequency games II.Term structure games III. Historical/implied games

I. Frequency Games

SPX 2006 to 2011 Data

Historical volatility tends to depend on the sampling frequency
Data from 2006 to 2011 25 24.5 24

Historical Volatility

23.5 23 22.5 22 21.5 21 20.5 20 0 5 10 15

Periodicity

SPX 2006 Data

10

Data from 2006

9.5

Historical volatility

8.5

7.5

10

15

Periodicity

SPX 2007 Data

16.5 16 15.5

Data from 2007

Historical volatility

15 14.5 14 13.5 13 12.5 12

10

15

Periodicity

SPX 2008 Data

42

Data from 2008

40

Historical volatility

38

36

34

32

30

10

15

Periodicity

SPX 2009 Data

27.5

Data from 2009

27

Historical volatility

26.5

26

25.5

25

10

15

Periodicity

SPX 2010 Data

18.2

Data from 2010

18

Historical volatility

17.8

17.6

17.4

17.2

17

16.8

10

15

Periodicity

SPX 2011 Data

Data from 2006 to 2011 23.5 23 22.5

Historical Volatility

22 21.5 21 20.5 20 19.5 19 18.5 0 5 10 15

Periodicity

Historical Vol / Historical Vol Arbitrage

If weekly historical vol < daily historical vol : buy strip of T options, -hedge daily sell strip of T options, -hedge weekly Adding up : do not buy nor sell any option; play intra-week mean reversion until T; final P&L :

RVTdaily RVTweekly

RVTdaily RVTweekly

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Daily Vol / weekly Vol Arbitrage

-On each leg: always keep $ invested in the index and update every t -Resulting spot strategy: follow each week a mean reverting strategy -Keep each day the following exposure:

.(
where

1 1 ) S t i , j S t i ,1

ti , j is the j-th day of the i-th week

-It amounts to follow an intra-week mean reversion strategy

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Intra week mean reversion strategy

Data from 05/04/2009 to 05/18/2009 930 925 Short 920 915 Short

SP500

910 905 900 895 890 885 880 1 2 3 4 5 6 7 8 9 10 11 Long Long

II. Term Structure Games

VIX and VSTOXX

VIX and VSTOXX

SPX and VIX (MR portfolio)

SPX Index and VIX Index Data from 4/1/2010 to 4/1/2012 50 45 40 35 30 25 20 15 10 900

VIX Index

950

1000 1050 1100 1150 1200 1250 1300 1350 1400 1450

SPX Index

SPX and VIX (MR portfolio)

SPX Index and VIX Index Data from 4/1/2010 to 4/1/2012 50 45 40 35 30 25 20 15 10 900

VIX Index

950

1000 1050 1100 1150 1200 1250 1300 1350 1400 1450

SPX Index

SPX and VIX (MR portfolio)

SPX Index and VIX Index Data from 4/1/2010 to 4/1/2012 50 45 40 35 30 25 20 15 10 900

VIX Index

950

1000 1050 1100 1150 1200 1250 1300 1350 1400 1450

SPX Index

SPX and VIX (MR portfolio)

Time series of portfolio P&L 5 5 Occupation time 4 4

-1

200 Time

400

600

-1

50

100

150

SPX and VIX (MR portfolio)

Time series of portfolio P&L 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 -0.5 04/01/10 09/06/10 02/11/11 Time 07/20/11 12/25/11 06/01/12

SPX and VIX

SPX Index and VIX Index Data from 4/1/2010 to 4/1/2012 50 45 40 35 30 25 20 15 10 900

VIX Index

950

1000 1050 1100 1150 1200 1250 1300 1350 1400 1450

SPX Index

SPX and VIX

SPX Index and VIX Index Data from 4/1/2010 to 4/1/2012 50 45 40 35

VIX Index

30 25 20 15 10 5 0 900 950 1000 1050 1100 1150 1200 1250 1300 1350 1400 1450

SPX Index

SPX and VIX

SPX and VIX Data from 4/1/2010 to 4/1/2012 50 45 40 35 30

VIX

25 20 15 10 5 0 950 1000 1050 1100 1150 1200 1250 1300 1350 1400

SPX

SPX and VIX

Time series of portfolio P&L 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 -0.5 0 200 Time 400 600 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 -0.5 0 50 100 150 Occupation time

SPX and VIX

Time series of portfolio P&L 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 -0.5 04/01/10 09/06/10 02/11/11 Time 07/20/11 12/25/11 06/01/12

VIX and V2X (MR portfolio)

VIX Index and V2X Index Data from 1/1/2009 to 9/10/2011 60 55 50 45

V2X Index

40 35 30 25 20 15 10

20

30

40

50

60

70

VIX Index

VIX and V2X (MR portfolio)

VIX Index and V2X Index Data from 1/1/2009 to 9/10/2011 65 60 55 50

V2X Index

45 40 35 30 25 20 15 10 20 30 40 50 60 70

VIX Index

VIX and V2X (MR portfolio)

VIX Index and V2X Index Data from 1/1/2009 to 9/10/2011 65 60 55 50

V2X Index

45 40 35 30 25 20 15 10 20 30 40 50 60 70

VIX Index

VIX and V2X (MR portfolio)

Time series of portfolio P&L 7 6 5 4 3 2 1 0 -1 7 6 5 4 3 2 1 0 -1 Occupation time

200

400 Time

600

800

50

100

150

200

VIX and V2X (MR portfolio)

Time series of portfolio P&L 7 6 5 4 3 2 1 0 -1 -2 01/01/09

09/26/09

06/22/10 Time

03/17/11

12/11/11

09/05/12

VIX Futures
34 32 30 28 26 24 22 20 18

2-D representation

VIX futures

Jan

Feb

Mar

Apr

Maturity

VIX Futures and VStoxx Futures

34 32

2-D representation

VIX & VStoxx Futures

30 28 26 24 22 20 18

Jan

Feb

Mar

Apr

Maturity

VIX Futures and VStoxx Futures

45

2-D representation

40

VIX & VStoxx Futures

35

30

25

20

Jan

Feb

Mar

Apr

Maturity

III. Historical/Implied Games

Historical/implied moments
Volatility Skew: slope of implied volatility as a function of Strike Link with Skewness (asymmetry) of the Risk Neutral density function ? Moments 1 2 3 4
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Statistics Expectation Variance Skewness Kurtosis

39

Finance FWD price Level of implied vol Slope of implied vol Convexity of implied vol

S&P 500: Option Prices

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Non parametric fit of implied vols

40

SPX Implied Vols on 31-Jan-2o12 (1M)

35

Implied (%)

30

25

20

15

10 1000

1100

1200

1300

1400

1500

1600

1700

K
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Implied Volatilities

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Local Volatilities

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Risk Neutral Densities

0.01 0.009 0.008 0.007 0.006

Risk Neutral Density SPX on 31-Jan-2o12 (1M, 3M, 1Y)

PDF

0.005 0.004 0.003 0.002 0.001 0 500

750

1000

1250

1500

1750

2000

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Theoretical Skew From Price History

Theoretical Skew from Prices

? =>
Problem : How to compute option prices on an underlying without options? For instance : compute 3 month 5% OTM Call from price history only. 1) Discounted average of the historical payoffs. Bad : depends on bull/bear, no call/put parity. 2) Generate paths by sampling 1 day return recentered histogram. Problem : CLT => converges quickly to same volatility for all strike/maturity; breaks autocorrelation and vol/spot dependency.
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Theoretical Skew from Prices (2)

3) Discounted average of the Intrinsic Value from recentered 3 month histogram. 4) -Hedging : compute the implied volatility which makes the hedging a fair game.

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Strike dependency
Fair or Break-Even volatility is an average of squared returns, weighted by the Gammas, which depend on the strike

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Strike dependency for multiple paths

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Theoretical Skew from historical prices

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S&P500 2006
SP500 1/3/2006 to 1/3/2009 BEVL surface 1/3/2006 Implied vol surface 1

0.8

0.6

0.4

0.2

0 80 90 100 110 120 1m 3m 2m maturity 1y 6m 18m 2y

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moneyness

51

S&P500 2008
SP500 10/1/2008 to 11/22/2010 BEVL surface 10/1/2008 Implied vol surface 0.65 0.6 0.55 0.5 0.45 0.4 0.35 0.3 0.25 0.2 80 90 100 110 120 1m 2m 3m 6m 1y 18m 2y

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moneyness

52

maturity

Conditional Realized Variance

Assume dSt = vt dWt , then E[vt ST = K ] E[vt S t' = E[ St ST = K ]] = vloc ( E[ S t ST = K ], t ) It follows that E[ RVT ST = K ] = E[ vt dt ST = K ] = E[vt ST = K ] dt
0 0 2 = vloc ( E[ S t ST = K ], t ) dt impl (K ,T )T 0 T T T

In summary
2 ( K , T ) T E[ RVT ST = K ] impl

We apply this approximation to historical realized variance

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S&P500 example
Realized Variance vs Final Return 0.12

0.1

0.08 Realized Variance

0.06

0.04

0.02

0 85

90

95

100 Final Return

105

110

S&P500 example
Realized Vol vs Final Return 0.4 0.35

0.3

Realized Vol

0.25

0.2

0.15

0.1

0.05 85

90

95

100 Final Return

105

110

Density extracted from previous skew

0.12

0.1

0.08

0.06

0.04

0.02

0 85

90

95

100

105

110

Summary
We can play with volatility even without options Term structure of volatility can be exploited Careful with implied/historical games More complex games with more dimensions

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