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Practical applications
Volatility dispersion strategies involve selling volatility on the index and buying volatility on the components, traditionally using at the money (ATM) straddles. A problem with this approach, however, is that as the orginal ATM options move out-of-the-money, they lose their vega exposure. To correct this problem, a new style of trading has emerged the 'variance swap' approach, which eliminates the constant rebalancing requirement associated with ATM options. Moreover, under variance swap methodology, the volatility difference appears more tame.
Abstract
Several trading institutions are actively engaged in 'volatility dispersion' strategies. These involve selling volatility on the index and buying volatility on the components. This trade was traditionally done using at the money (ATM) straddles. An important practical problem with this approach is that market prices move and cause the original ATM options to become out of the money (OTM) and lose their vega exposure. Even if volatility moved as expected by the trader, the profit potential of the trade would be greatly diminished as the options lost their vega. To correct this problem, a new style of trading has emerged in which some practitioners are trading this strategy using a 'variance swap' approach. This has the advantage that both legs of the trade have relatively constant vega exposure, regardless of stock market movements.
INTRODUCTION
This paper reviews the volatility dispersion trade and compares the two approaches. It gives a heuristic motivation to the variance swap style of the trade. It also provides some empirical evidence that seems to indicate that the variance swap approach is more malleable to trading.
STYLES OF PROPRIETARY TRADING
It is useful to distinguish between two 'extreme' types of trading.
(1) Simple relationships: these seek to exploit slight price differences between identical products on different exchanges or products whose prices are tied to one another by an exact, pre-defined formula. These trades typically have very low risk and low expected profits. They rely on extremely efficient execution. Owing to the proliferation of fast electronic trading tools in the last several years, the opportunities for these trades have been rapidly diminishing. Examples are:
(a) The existence of several different option exchanges in the USA, which, at times, allows one to find zero cost 'butterflies' or other combinations of options...