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2015

Swiss Institutional
Investors Conference
1
Investments Workshop 7

A Robust Approach to Volatility


Trading

Alexandre Capez
Managing Director, Head of Quantitative Risk Strategies
Investment Banking
Credit Suisse
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A Robust Approach to Volatility Trading

This material is solely directed at Professional Clients and Eligible Counterparties as defined by the FCA,
and is not directed at, and should not be relied upon by, Retail Clients.

Alexandre Capez
16th September 2015
Wider Spectrum of Volatility Instruments Over the Years

Listed Options started trading in 1973


Isolating the volatility exposure from option positions requires daily delta-hedging
Path-dependency of volatility exposure (volatility exposure of an option is not
1970 - 1990 constant)

Variance Swaps began trading in the OTC market


Isolate pure exposure to volatility (more specifically, to variance)
1990s Provide exposure to realised or implied volatility (through forward variance swaps)

VIX & VSTOXX Futures & Options began trading


Traded as listed instruments on the exchange
2000s Provide exposure only to implied volatility

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Typography of Investors
Which Purpose Trading Volatility For?

Volatility trading is commonly used to achieve a variety of portfolio solutions:

Tactical opportunities may Take advantage of the negative


arise in relative value volatility correlation between volatility &
positions across different equity
underlyings Dynamic strategies can help
minimise the cost of carry
Relative Value Portfolio
Opportunities Hedging

Yield Absolute
Enhancement Return
Call overwriting is a Earn the cost of carry by
popular yield enhancement taking short volatility
mechanism to boost returns exposure
from equity holdings Dynamic or hedged approach can
help minimise tail risk

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Who Trades Volatility?

Hedge Funds Asset Managers


Market Makers Insurance Companies
Family Offices

Relative Value Portfolio


Opportunities Hedging

Yield Absolute
Enhancement Return
Retail Investors Asset Managers
Asset Managers Insurance Companies
Family Offices
Retail Investors
Hedge Funds

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Volatility Properties at a Glance
Realised Volatility Backward Looking

Realised Volatility is an objective, formulaic measure of historical market risk


Represents the standard deviation of returns over a given period
Volatility is typically expressed as an annualised figure

105 105
2.6% 1.8% 0.4%
1.2%
104 1.3% 104 0.4%
0.4%
1.6% 0.4%
103 103 0.4%
0.4%
-0.7%
-1.5% 0.3%
102 1.5% -2.0% 102
0.3%
0.3%
101 -1.2% 101 0.3%
-0.4% 0.3%

100 100
Day 1

Day 2

Day 3

Day 4

Day 5

Day 6

Day 7

Day 8

Day 9

Day 10

Day 11

Day 12

Day 1

Day 2

Day 3

Day 4

Day 5

Day 6

Day 7

Day 8

Day 9

Day 10

Day 11

Day 12
Volatility: 24.4% Volatility: 5.7%

Source: Credit Suisse, FOR ILLUSTRATIVE PURPOSES ONLY


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Implied Volatility Forward Looking

Implied Volatility is a subjective measure derived from the market price of options
Influenced by demand and supply of options
Can be seen as a measure of market sentiment or perceived risk

Black-Scholes
Option Valuation

Spot Price

Market Price for Strike Price


Implied Volatility
Option
Interest Rate

Time to maturity

Volatility

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Negative Correlation with Equities

90 1800
80 1600
70 1400
60 1200
50 1000
40 800
30 600
20 400
10 200
0 0
Jan 00 Jul 01 Jan 03 Jul 04 Jan 06 Jul 07 Jan 09 Jul 10 Jan 12
S&P 500 Volatility Index (LHS) S&P 500 Index (RHS)

Source: Credit Suisse & Bloomberg (Data from Jan 2000 June 2013)
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Mean Reverting Behaviour

90
80
70
60
50
40
30
20
10
0
Jan 00 Jul 01 Jan 03 Jul 04 Jan 06 Jul 07 Jan 09 Jul 10 Jan 12
S&P 500 Volatility Index Average

Source: Credit Suisse & Bloomberg (Data from Jan 2000 June 2013)
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Term Structure in Contango
Volatility Level
45

40

35

30

25

20

15

10
1st 2nd 3rd 4th 5th 6th 7th 8th 9th
Expiry Expiry Expiry Expiry Expiry Expiry Expiry Expiry Expiry
Contango Backwardation

The cost of carry is determined by the shape of the termstructure


Source: Credit Suisse, FOR ILLUSTRATIVE PURPOSES ONLY
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Negative Skew: Put IV > Call IV

There is a premium to pay for downside protection


Source: Bloomberg, 25 August 2015
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Investing in Volatility is Not Straightforward

90 250000
80
70 200000

60
150000
50
40
100000
30
20 50000
10
0 0
Jun 07 Jun 08 Jun 09 Jun 10 Jun 11 Jun 12 Jun 13
VIX Index (LHS) VIX Short-Term Futures Index (RHS)

Cost of carry is a direct consequence of contango so why not doing the opposite?
Source: Credit Suisse & Bloomberg (Data from June 2007 June 2013)
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Volatility Carry: A Slippery Fish
Which Sources of Alpha Can be Derived From Volatility?

Expensiveness of
Implied versus Realized
Volatility Term Structure / Roll
Down

Key Volatility Risk


Premia Themes

Expensiveness of Other:
Volatility of Volatility Dynamics of
Skew/Kurtosis
Statistical Relationships

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Expensiveness of Implied Versus Realized Volatility

Spread (VIX - SPX 20d Realised Volatility) Average

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20 Pct Rank Spread


90 8.6
80 6.8
10
70 5.6
60 4.8
0 50 4.0
40 3.3
-10 30 2.4
20 1.1
10 -0.8
-20
Here is the issue! 0 -27.4

-30 Average 3.7


StDev 4.5

-40
May 00 May 02 May 04 May 06 May 08 May 10 May 12 May 14

Source: Credit Suisse & Bloomberg (Data from May 2000 May 2015)
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Term Structure/ Roll Down

Spread (VIX 2M Future - VIX 1M Future)


10

-5

-10
Here is the issue!

-15

-20
Apr 08 Apr 09 Apr 10 Apr 11 Apr 12 Apr 13 Apr 14 Apr 15

Pct Rank Spread 2M-1M Spread 3M-2M Spread 4M-3M Spread 5M-4M Spread 6M-5M
Average 0.7 0.4 0.3 0.3 0.3
StDev 1.8 1.1 0.8 0.6 0.5

Source: Credit Suisse & Bloomberg (Data from April 2008 June 2015)
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How to Extract These Sources of Alpha?

Expensiveness of
May be harvested by selling listed equity options and delta-hedging them
Implied versus
on a daily basis or by selling an OTC variance swap.
Realized Volatility

May be harvested through the VIX future term structure by selling the
Term Structure /
short end of the curve and buying further out. This strategy requires a
Roll Down
constant rebalancing to ensure a constant duration.

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Implied vs. Realised: Short SPX Options Daily Delta Hedged
Rationale

Monetising expensiveness of
implied volatility versus realised
volatility on the SPX

Implementation

Sell every month SPX short


term downside puts delta
hedged on a daily basis

Timing Signal

No signal

Risk Exposure

Vega: -0.5%

Source: Credit Suisse, Bloomberg. All figures based on data from 22 May 08 to 25 Aug 15. Past performance (actual or simulated) is not an indicator of future
performance. The results presented are historical simulated results. As of 25 Aug 12 the strategy is not yet live and all data shown is for illustrative purpose only. This
information is subject to change at any time in the full discretion of Credit Suisse. The terms outlined herein do not constitute an offer by Credit Suisse to enter into any
transaction. The strategy returns are net of a 0.25%pa calculation fee.
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Term Structure/Roll Down: Short VIX Future Roll Down
Rationale

Monetising the natural roll


down (negative carry) of VIX
term structure

Implementation

Sell 2 month duration rolling


VIX future versus long 3
month duration rolling VIX
future

Timing Signal

No signal

Risk Exposure

Vega Spread: 1% per Leg

Source: Credit Suisse, Bloomberg. All figures based on data from 22 May 08 to 25 Aug 15. Past performance (actual or simulated) is not an indicator of future
performance. The results presented are historical simulated results. As of 25 Aug 12 the strategy is not yet live and all data shown is for illustrative purpose only. This
information is subject to change at any time in the full discretion of Credit Suisse. The terms outlined herein do not constitute an offer by Credit Suisse to enter into any
transaction. The strategy returns are net of a 0.25%pa calculation fee.
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Virtual or Real Alpha
Alpha Comes and Goes. Outsmart It But With Caution!

Equity volatility nave Alpha has declined over the past few years as seen
previously (despite a good start of the year in 2015)

This has led to a need for alternative solutions or smart Alpha to compensate
for lack of returns

however, this search for which unfortunately can end up searching Alpha
where there is none!

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Red Flags
Here is a sample of algorithmic volatility trading strategies which gathered a few billion in assets.
Sharp deterioration in performance as soon as strategies went live a consequence of
unintentional data mining ?

Source: Bloomberg (Data from June 2006 July 2014)


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Red Flags
Some of the common traps on systematic strategies may attributed to the below effects:

Multiplication of Embedded Signals in the Strategy:


With four parameters I can fit an elephant, and with five I can make him wiggle his trunk
John Von Neumann

Lack of Fundamentals:
The fallacy of: Post hoc ergo propter hoc (After this, therefore because of this)
Correlation does not imply Causation
Noise can be confused with signal in many ways Blinded by Optimism (Winton Capital, 2013)

Selection Bias:
Selecting best-in-class strategies among a universe of backtested performance decreases the
likelihood for the selected strategy to be effective. The bigger the sample of backtested strategies
the smaller the probability for the strategy to perform.

Survivorship Bias or Silent evidence (The Black Swan, Nassim Taleb)


Extrapolation of the Selection bias: A PM selecting CTAs purely based on performance and
discarding poor strategies is likely to suffer regression to the mean

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A Practical Example of Overfitting

By construction it is easier for a multi-factor strategy with a large number of degrees of


freedom to fit the historical data without necessary a predictive role.

Source: Credit Suisse, FOR ILLUSTRATIVE PURPOSES ONLY


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A Robust Approach to Volatility Trading
Our Approach to Strategy Development

We believe that the development and construction of


systematic strategies requires a deep knowledge and Literature about systematic strategies highlights
understanding of the underlying market as well as risks and concerns over their construction:
rigorous checks and balances to ensure the integrity
of the strategy Nobody has ever lost money on a spreadsheet.

Over the years, a number of academics and market -Attain Capital


professionals have highlighted the risks and potential
challenges of developing systematic solutions Based on a large universe of ETFs, backtested
performance has over performed live performance by
A commonly quoted risk of systematic strategies is
more than 10%.
over fitting as well as survival bias at the
development stage
- Vanguard 2012 study
The difference between in-sample performance and
out-of-sample performance in systematic strategies Other references : Pseudo-Mathematics and
has historically been significant in many cases Financial Charlatanism: The Effects of Backtest
Overfitting on Out-Of-Sample Performance. (D.
Credit Suisse aims to minimise these risks as much Bailey, J.M. Borwein, M. Lopez de Prado, Q.J.
as possible through the development of a rigorous Zhu)
and thorough investment process

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Volatility Investing In 2 Steps

Strategy Rule based strategies with strong fundamentals using transparent


Design and liquid volatility underlyings and designed with risk budgeting

Portfolio Dont put all your eggs in the same basket! Benefits of
Construction diversification can be seen even within the volatility asset class.

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Strategy Design: Investment Process

Checklist Safeguards

Look for high causality signals / sustainable Ensure controls are in place for the general
risk premia leverage inherent within the portfolio
Aim: Generate performance

Ensure robustness of all parameters Detailed implementation at strategy level

Aim: Mitigate losses


Approach strategies from a drawdown
Challenge stability of any signals
perspective

Minimise the number of variables / degrees


Conduct VaR Testing
of freedom

Test the statistical validity of trading


Test the historical unknown
frequency

Ensure sound and rationale implementation Constrain greeks exposures within the
mechanism strategy

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Building Blocks Approach
From Alpha Generation to Tail Risk Protection

13. VIX Future Roll


8. Short VIX Call Down Conditional to
3. Short 1 Month Spreads Backwardation
Rolling VIX Future
Conditional to on IV
vs. RV Signal 9. Short VIX Call
14. Long VIX 4
Spreads
Month Future
Conditional to Term
Conditional to IV vs.
Structure
4. Short VIX 1 RV
Month Rolling
Conditional to 5. Short Gamma 12. VIX Roll Down
Skew/Kurtosis Through Listed with VIX Option
16. Short VIX 1 by 3
1. Short Signal Options Conditional Gap Risk
Call Ratio
Variance Swap to Cash Signal Protection

Long Volatility
Short Volatility Protection
High Carry

10. Long VIX Puts


6. Short VIX Future Conditional to
Roll Down Option Premium 15. Long VIX 1
2. Short Delta Month Rolling
Hedged VIX Future Conditional
Straddles 7. Short VIX Future 11. Statistical VIX to Skew/Kurtosis
Roll Down Future
Conditional to Term Momentum/Mean
Structure Concavity Reversion

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Portfolio Construction

From building blocks . to portfolio construction

2
1 3 4
6 Strate Strate Strate
5 7 8 gy 2 gy 2 gy 2
9 11 7 11 4
13 10
14 12 Strate Strate Strate
15 16 gy 2 gy 2 gy 2
1 16 13

Each strategy can be considered as Portfolio construction should be


a building block which can be tailored to the investors own utility
incorporated a portfolio function
Each building block is designed to Portfolio construction should aim to
represent a single risk premia, and provide diversification by combining
as such a portfolio approach to strategies displaying low pairwise
investing would allow the investor to correlations
exploit benefits of diversification

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Portfolio Construction: Example of Balanced Portfolio

Out of the 16 strategies considered, we have selected 4 volatility strategies which each aim to
capture a different form of volatility risk premia.

Strategy Description Risk Premium Source


Short VIX 1 Month Rolling Conditional Difference between short term VIX future
3 to IV vs. RV Signal levels and the level of the VIX Index.

Short Gamma Through Listed Options Difference between implied and subsequent
5a Conditional to Cash Signal (EU) realised volatility on the EuroSTOXX 50
Index.
Short Gamma Through Listed Options Difference between implied and subsequent
5b
Conditional to Cash Signal (US) realised volatility on the S&P 500 Index.
Long VIX 4 Month Future Conditional to Paying risk premium (slope of the VIX term
14 IV vs. RV structure) to gain long volatility exposure.

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Portfolio Construction: Fundamental Diversification

Select strategies which should fundamentally


display low correlations

Forward Short VIX 1 Month Rolling Conditional to IV vs.


Volatility RV Signal
3
Exposure

Upside Short Gamma Through Listed Options Conditional


Short Short to Cash Signal (EU)
Volatility 5a
Spot Gamma
Volatility
Downside Short Gamma Through Listed Options Conditional
Exposure
Short 5b to Cash Signal (US)
Gamma

Long VIX 4 Month Future Conditional to IV vs. RV


Long
Volatility 14

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Historical Correlation Between the 4 Volatility Strategies:
The historical, simulated correlation between each component strategy has been relatively low,
indicating a potential diversification benefit when combining them within one investment.
Historical (simulated) rolling 120-day correlations between the component strategies:

80% (Strategy 3 v. 5a) (Strategy 3 v. 14) (Strategy 5a v. 5b)


(Strategy 3 v. 5b) (Strategy 5a v. 14) (Strategy 5b v. 14)
60% Average Correlation
40%

20%

0%

-20%

-40%
Jun 08 Jun 09 Jun 10 Jun 11 Jun 12 Jun 13 Jun 14

Source: Credit Suisse, Bloomberg. All figures based on data from 03 Jan 08 to 13 May 15. Past performance (actual or simulated) is not an indicator of future performance. The
component strategies are live, all data shown prior to their respective live dates is purely for indication purposes. The returns are net of a 0.25% p.a. calculation fee within each
component strategy. Proforma date: 03 Jan 2008 36
Historical Performance: Overview
Historical Performance Performance Statistics
200 Strategy is not yet live, all data shown is indicative
Annualised Return 8.5%
180
Annualised Volatility 4.3%
160
Sharpe Ratio 1.90
140
120
Maximum Drawdown -5.7%
100
Maximum Time to Recovery (days) 97
80 Average Time to Recovery (days) 10
60 Calmar Ratio 1.50
40
20 Average Monthly Performance 0.7%
0 Best Monthly Performance 5.9%
Jan 08 Jan 09 Jan 10 Jan 11 Jan 12 Jan 13 Jan 14 Jan 15 Worst Monthly Performance -3.3%
Balanced Portfolio %age of Positive Months 75.9%

Average Daily Performance 0.0%


Best Daily Performance 1.8%
(Simulated) Monthly Performance Worst Daily Performance -1.8%
%age Positive Days 54.3%
Jan Feb Mar Apr May June July Aug Sept Oct Nov Dec Year
Average Positive Day 0.2%
2007
Average Negative Day -0.1%
2008 0.1% -0.1% 1.5% 0.7% -1.4% 1.1% 0.4% 1.0% 4.8% -2.8% 5.9%
2009 -3.3% 0.5% 0.0% 4.2% 1.7% 1.6% -0.2% 0.7% 0.7% -1.1% 0.4% 2.4% 7.7%
2010 1.6% 0.7% 2.9% 0.3% 2.4% -1.5% 1.4% 0.4% 1.9% 1.8% 1.1% 1.0% 14.8%
2011 1.1% 0.5% 0.4% 3.1% 0.6% 0.0% -0.4% 1.5% -1.3% 2.8% 1.6% 2.7% 13.4%
2012 1.2% 0.6% 0.1% -0.8% -1.6% 0.2% 1.5% 1.5% 0.9% 0.3% 0.2% 0.5% 4.7%
2013 1.7% -0.5% 0.5% 0.0% 1.3% 0.0% 1.3% 0.7% 1.0% 0.6% 0.3% 0.0% 7.1%
2014 0.4% 0.0% -0.3% -0.7% 0.8% 1.6% -0.7% 0.0% 0.3% 0.4% 0.5% -0.9% 1.3%
2015 1.1% 2.0% -0.7% 0.8% 3.1%

Source: Credit Suisse, Bloomberg. All figures based on data from 03 Jan 08 to 13 May 15. Past performance (actual or simulated) is not an
indicator of future performance. The Balanced Portfoliois not yet live and all data shown is purely for indication purposes. The Index returns are
net of a 0.25% p.a. calculation fee within each component strategy and a 0.50%p.a. basket fee. Proforma date: 03 Jan 2008
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Disclaimer (1/2)
IMPORTANT NOTICE PLEASE READ

These materials do not constitute an offer or a solicitation of an offer to buy or sell investment products or securities, nor do they constitute a prospectus for
any securities, nor do they otherwise constitute an agreement to provide investment services. These materials are provided for information purposes only and
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Disclaimer (2/2)
All projections, valuations and analyses are provided to assist you in the evaluation of the matters described herein and (i) may be based on subjective assessments and
assumptions, (ii) may use one among alternative methodologies that produce different results and (iii) to the extent they are based on historical information, should not be relied
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