Beruflich Dokumente
Kultur Dokumente
trading
Artur Sepp
artursepp@gmail.com
1
Electronic copy available at: https://ssrn.com/abstract=3032098
Headlines
1. Present some empirical evidence for short volatility strategies and the
cyclical pattern of their P&L: alpha in good times, beta in bad times
2
Electronic copy available at: https://ssrn.com/abstract=3032098
Short volatility strategies out-perform the benchmark
CBOE indices related to short volatility strategies (not delta-hedged)
The longest time series from 1986 including 87’ crash, 07’ GFC
3
Short volatility strategies out-perform the benchmark in
the long-term by a wide margin
S&P500 Call Put
1$ Value 8.2 × 1.4 × 2.0
16 1$ investment
S&P 500 index
12
Call Index
Put Index
8
0
Jun-86
Jun-90
Jun-94
Jun-98
Jun-02
Jun-06
Jun-10
Jun-14
4
Out-performance of short volatility strategies is related
to the risk-premium in implied volatility
Implied volatility is a measure of volatility at which options are quoted/traded
in the market (Black-Scholes vol)
Realized volatility is a measure of price-returns volatility to replicate op-
tion pay-offs by delta-hedging
Volatility Risk-premium = Implied volatility − Realized volatility
Figure: Proxy of volatility risk-premium =
VIX at month start−Realized volatility of S&P500 daily returns in this month
Volatility Risk-Premium
20%
0%
-60% -1 StandardDeviation=-5%
Jul-86
Jul-90
Jul-94
Jul-98
Jul-02
Jul-06
Jul-10
Jul-14
5
Straddle is the strategy for monetizing the volatility risk-
premium
Short Straddle = short at-the-money put and call options
10%
Straddle Pay-off
5%
0%
-5%
Price return
-10%
-10% -5% 0% 5% 10%
6
Skew risk-premium in implied volatility is more signifi-
cant than the volatility premium
Volatility skew measures how implied (at-the-money) or statistical (real-
ized) volatility changes when the index changes
Volatility skew is negative because of the leverage effect
Implied skew = (105% Call Vol − 95% Put Vol) / 5%
Realized skew is measured by the volatility beta
Figure: Proxy of skew risk-premium =
1m Implied Skew−1m Realized skew of S&P500
10%
Risk-Reversal Pay-off
5%
0%
-5%
Price return
-10%
-10% -5% 0% 5% 10% 8
The volatility risk-premium is realized by selling options
at implied volatility net of realized volatility as costs for
delta-hedging
”Look deep into nature, and then you will understand everything better”
- Albert Einstein
9
Risk-aversse investors assign larger weights for negative
returns
”Individuals are risk averse if they always prefer to receive a fixed payment
to a random payment of equal expected value” - Dumas&Allaz (1996)
1.0
0.5
Future return
0.0
-5 0 5 10
The valuation measure with risk-aversion assigns higher
probability to negative returns if price-returns under the
statistical measure are fat-tailed
Risk-averse investors are ready to pay more to buy options for protecting
against negative returns
Figure: The statistical measure with zero skeweness and large excess
kurtosis of size 11.0 (daily returns for S&P500 index)
The valuation measure with risk-aversion implies large negative
skeweness even if the statistical distribution has no skeweness
Statistical Measure Valuation Measure
Implied Skeweness 0.00 -1.04
Fat-tailed PDF (Log-scale)
Statistical Measure
Valuation Measure
with Risk-Aversion
Future Return
-5 -3 -1 1 3 5 11
Model implies that the volatility risk-premium arises from:
• Fat tails of the statistical distribution of returns
• Investors’ risk-aversion
As driver for P&L:
Risk-premium = Implied risk − Realized risk
risk = volatility, skew, kurtosis
Statistical Measure
Implied Option Vol
Valuation Measure
with Risk-aversion
Skew
Premium
Volatility
Premium
When the index goes down, realized vol of P&L of short index puts
increases due to negative gamma and vega so put sellers need to charge
extra premium for negative covariance between price-returns and P&L vol
13
Empirical evidence: risk aversion leads to higher realized
returns on short volatility strategies
Modify my theoretical equation for the expected return under the risk-
aversion into a factor model:
StrategyReturn = βM arket × MarketReturn + βV olP remium × VolPremium + α
15
To generate alpha from selling volatility, we need to
model market cycles and size positions accordingly
In good times:
• Exposure to index returns is removed by delta-hedging
• Residual risks of volatility premiums (gamma, vega) are idiosyncratic
so for diversified portfolio these are negligible
In bad times:
Residual risks become common with risk-premiums spiking down
Left figure: QQ-plot of monthly returns on the S&P 500 from 1986
Right: QQ-plot of monthly returns normalized by the realized historic
volatility of daily returns within given month
Using statistical tests for normality of returns:
• Strong presumption against normality of returns
• Cannot reject normality of volatility-normalized returns
Data Quantiles
50%
0%
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jan-14
Jan-15
19
Regime identification and their probabilities are applied
for optimal position sizing
Maximize the log of investment value to obtain the Kelly betting rule
conditional on market regimes:
Expected Return In Normal Regime
Position In Normal Regime =
Variance of Return In Normal Regime
Expected Return In Stressed Regime
Position In Stressed Regime =
Variance of Return In Stressed Regime
20
Volatility selling using 1m delta-hedged short Straddle
on the S&P500 index - the strategy with optimal posi-
tion sizing outperforms
Daily re-hedging and weekly re-balancing
Transaction costs: 5bp per spot, 1% per implied vol
• Continuous: roll into new straddle every week
• Optimal: size position using out-of-sample forecast of regime probabilities:
No trading when forecast probability of stressed regimes is high
Continuous Optimal %
Trades # 519 173 33%
Sortino -0.39 0.98
Sharpe -0.34 0.74
40,000 Continuous
Straddle P&L Optimal Sizing
20,000
-20,000
-40,000
-60,000
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jan-14
Jan-15
21
Volatility trading with 1m straddles on the S&P500 in-
dex - the strategy with optimal long/short positions
Long/short am Straddle with daily re-hedging and weekly re-balancing
40,000
20,000
-20,000
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jan-14
Jan-15
22
Skew selling using risk-reversals on the S&P500 index -
the strategy with optimal position sizing outperforms
1m delta-hedged short 97.5%-102.5% Risk-reversal with daily re-hedging
and weekly re-balancing
10,000
-10,000
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jan-14
Jan-15
23
From signal generation to hedging - empirically consis-
tent delta-hedging does contribute to the alpha
1) Signal generation
2) Delta-hedge execution
24
Key result: for the minimum-variance delta, the choice
of any particular stochastic or local vol model is irrele-
vant if models are calibrated to same implied vol surface
25
The volatility dynamics are log-normal: the basis for
vol-of-vol (normal, log-normal, 3/2) is important for sta-
tionary model with time-independent parameters
Compute the empirical frequency of one-month implied at-the-money
(ATM) volatility proxied by the VIX index for last 20 years
Daily observations normalized to have zero mean and unit variance
Left figure: empirical frequency of the VIX - it is definitely not normal
Right figure: the frequency of the logarithm of the VIX - it does look
like the normal density, especially for the right tail!
7% Empirical frequency of 7% Empirical frequency of
6% normalized VIX 6% normalized logarithm of the VIX
5%
Frequency
Empirical 5% Empirical
Frequency
4% Standard Normal 4% Standard Normal
3% 3%
2% 2%
1% 1%
VIX Log-VIX
0% 0%
-4 -3 -2 -1 0 1 2 3 4 -4 -3 -2 -1 0 1 2 3 4
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Empirical frequency of realized vol is also log-normal
Compute one-month realized vol of daily returns on the S&P 500 index
for each month over non-overlapping periods for last 60 years from 1954
- normalize to have zero mean and unit variance
Frequency
Empirical
Frequency
6% Empirical 6%
Standard Normal Standard Normal
4% 4%
2% 2%
Vol Log-Vol
0% 0%
-4 -3 -2 -1 0 1 2 3 4 -4 -3 -2 -1 0 1 2 3 4
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Beta SV model is factor model for changes in vol V (tn)
predicted by returns in price
"
S(tn): #
S(tn) − S(tn−1)
V (tn) − V (tn−1) = β + V (tn−1)n
S(tn−1)
iid normal residuals n are scaled by vol V (tn−1) due to log-normality
Left figure: scatter plot of daily changes in the VIX vs returns on S&P
500 for past 14 years and estimated regression model
Volatility beta β is a measure of realized skew with high R2 = 67%
Right: time series of residuals n - the regression model is stable across
different estimation periods
Volatility beta β: expected change in ATM vol predicted by price return
For return of −1%: expected change in vol = −1.08 × (−1%) = 1.08%
20% 30% Time Series of Residual Volatility
Change in VIX
In practice, this form is augmented with extras for convexity and tails
0
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jan-14
Jan-15
-1 30
Volatility skew-beta combines the skew and volatility
P&L together - positive change in ATM vol from neg-
ative return is reduced by skew
Given price return δS: S → S {1 + δS}
1) For ATM vol change
• Volatility change is predicted by regression skew-beta:
δσAT M (S) = SKEWBETA × SKEW × δS
18%
15%
12% Strike K%
90% 95% 100% 105% 31
Volatility skew-beta is applied to compute minimum-
variance delta ∆ for hedging against changes in price
and price-induced changes in implied vol
A) We adjust option delta for change in BSM implied vol at fixed strikes
0.0
-0.1
-0.12
-0.2
-0.3
-0.31
-0.4
StickyStrike StickyLocalVol Empirical 33
Incorporating trading signal + empirical hedging pro-
duces superior P&L for delta-hedging short 6m straddle
on EuroStoxx50
Back-test of monthly rolls into new vols with maturity of 6m from 2007
to 2015 with trading signals using inference for market regimes
Delta-hedging using empirical skew-beta outperforms significantly
0.6 0.54
0.47
0.4
0.2
0.0
StickyStrike StickyLocalVol Empirical
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Conclusions
In 1986, American economist Minsky proposed a financial stability theory:
”A fundamental characteristic of our economy is that the financial
system swings between robustness and fragility and these swings
are an integral part of the process that generates business cycles”
Implications
• Risk-premiums observed in short volatility strategies can be inter-
preted as costs for protecting against business and market downturns
• Volatility selling strategy needs to have an optimal and dynamic posi-
tion sizing with respect to the market regime, with regime probabilities
forecasted using new market data
• Alpha comes from the ability to avoid market downturns and empiri-
cally consistent hedging
• This approach provides further applications for portfolio allocations
and risk-management
• Similar approach for credit/high yield strategies (my presentation at
Global Derivatives 2015)
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References
Computing option delta consistently with empirical dynamics:
Sepp, A., (2014), “Empirical Calibration and Minimum-Variance Delta
Under Log-Normal Stochastic Volatility Dynamics”
http://ssrn.com/abstract=2387845
All statements in this presentation are the authors personal views and not
those of Bank of America Merrill Lynch.
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