Risk Latte - 1995-1996: Vanna, Vomma and the Dollar Mark Trades-Part II

1995-1996: Vanna, Vomma and the Dollar Mark Trades-Part II

Rahul Bhattacharya
May 20, 2006

Continuing on from part I..........

In 1996 the reverse occurred. The Dollar-Mark FX rate remained relatively stable and the implied volatility of the Dollar-Mark dropped from 12.5% (the previous year level) to around 8%. As this happened due to the action of the buy side there was a massive accrual of "double no-touch (range)" trades in Dollar-Mark at the start of 1996. And this left the market makers long volatility in Dollar-Mark. Hence they felt the need to make up the difference in the premium received and the probable payout (and the probability of the payout increased because as the year wore on Dollar-Mark remained range bound). The only way they could do so, i.e. make up for the difference in premiums, was to start shorting options. And that is what they did; they started selling ATM forward options in Dollar-Mark. The market makers reasoned that if the FX rate remained range bound and they had to payout on the range trade they would at least make up the losses from the premium received by shorting the options.

But as the Dollar-Mark FX rate remained range bound for an extended period of time the market makers felt compelled to sell more and more ATM forward options, i.e. they kept selling the volatility. A direct and obvious consequence of their action was that the market kept marking the volatility in Dollar-Mark lower and the spot practically became stationary. Moreover, since the range trades had negative convexity as the volatility continued to fall the market makers became more and more long vega which prompted them to sell even more options. Once again like the previous year all these market makers were, unfortunately, on the same side of the market and this massive selling of volatility created a huge vortex.

Once again the market makers totally ignored the sensitivity of vega with respect to the underlying spot and the volatility which created unrealistic pricing model for them.

Source: Article by Andrew Webb in Derivatives Strategy , November 1999 (www.Derivativesstrategy.com)

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