On Friday, November 9, 2007 the volatility index for Hong Kong stocks (as measured by Risk Latte's proprietary implied volatility index on the underlying Hang Seng index) hit 44.96%. This is a huge number - at least, put in the historical context. Implied volatilities of all the Asian indices (as measured by Risk Latte's vol indices) have been hitting record highs.

This may be a good time to sell - or buy - volatility in the stocks and the underlying indices. This means treating volatility as an asset class. Option traders have been treating volatility as an asset class for a long time; however, a large number of mainstream, cash investors and traders still see volatility as something like an abstract, perhaps mathematical, concept. To many, volatility is a qualitative description of the state of the markets. But "tradable" volatility is number and has numerical value at every point in time. As we have talked elsewhere in this site, volatility is as real an asset class as the stocks, bonds or currencies. You can either trade in HSBC stock or trade in the "volatility" of the HSBC stock.

How can we trade in volatility of the stocks or stock indices? There are three broad approaches / strategies to trade in volatility.

- Buying and selling delta hedged options on the underlying stocks or the stock index;

- Buying and selling straddles and strangles on the underlying stocks or the stock;

- Taking a position in volatility (variance) through volatility (variance) swaps;

The first strategy is as old as the Black-Scholes option pricing model is. An option - a call or a put - on an underlying stock (or any asset) is function of five variables, the underlying (spot) price, the strike price, risk free interest rate, time to maturity of the option and the volatility of the underlying stock (asset). If the interest rate remains constant throughout the life of the option (an unrealistic assumption, but works well in many pricing models) and the strike price is fixed, then the option price is a function of both the spot price of the underlying and the volatility of the underlying. As both the spot price and the volatility (of the underlying) changes the value of the option also changes. If somehow we can neutralize the impact of the spot price changes on the option price then the option price will become a function of only the volatility of the underlying. That is what is done in a delta hedged position. A trader who is long (buys) a call or a put option on a stock or a stock index (depending on his market view) will an opposite position in the underlying stock (or the stock index) in proportion of the delta. This neutralizes the impact of the spot price move in the stock on the option price and the trader's position becomes a long (buy) position in the volatility of the underlying stock.

If he wants to short (sell) the volatility, then he would have to short (sell) the underlying options and use delta hedging. This is a not a perfect and pure volatility trade and the exposure to volatility is not a 100%. This is because in practice one cannot create a perfect market neutral trade (delta hedging is always imperfect and frequent delta hedging comes with a cost). Therefore, no matter how hard the trader tries he ends up having some market exposure besides volatility exposure. Besides, as we mentioned above, interest rates are never constant and therefore, one is always exposed to the interest rates.

The second strategy, that of buying and selling straddles and strangles, to buy and sell volatility is an improvement of the first strategy. A straddle is a simultaneous purchase (or sale) of a call and a put option on an underlying asset (stock or stock index) with the same strike price and time to maturity. In a long straddle, also known as "bottom straddle", the trader's view is that the volatility of the underlying stock will increase further from the present levels and hence he goes long (buys) a call and put option at the same time, with the same expiry, on the underlying stock. If the volatility actually increases, in line with the trader's view, then the stock will move either up or down from its present position by a significant amount. It does not matter whether the stock prices goes up or down; as long as the price moves significantly in either direction during the life of the option the trader makes money (either from his call or from his put). The profit profile is V-shaped. A short straddle, or a "top straddle", is one in which the trader thinks that the volatility has topped, is at its peak (as some might be tempted to think now), and goes short on (sells) a call and put option on the underlying stock with the same strike price and the same expiry. If the volatility indeed decreases, vindicating the trader's view, then the stock price will neither move up or down by a significant amount - the movement of the stock price around the present levels will be quite small on either side - during the life of the option and the trader will make money from the premium it earned by selling the options. Of course, short straddle, is a far more riskier strategy than long straddle.

Volatility or variance swaps gives the trader a pure and perfect exposure to volatility of an asset (underlying). A volatility (variance) swap is similar to a forward contract and yet it resembles a call option in many aspects. Essentially, the trader, or the holder of the swap, agrees to swap the realized volatility at the end of the tenure with a strike level of volatility agreed at the initiation of the contract. It is a forward contract on future volatility entered today. A defining feature of a volatility (variance) swap is that it is synthetically created and it creates an exposure to a synthetic contract called the "log forward" or the "log contract" (natural logarithm of the forward or the spot price). A log contract, by its very construction, gives a 100% pure exposure to volatility of the underlying.

Even though a volatility (variance) swap is priced as weighted portfolios of calls and puts, with weights being function of strike levels, it gives a far greater - and purer - exposure to volatility of the underlying asset than options.

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