Volatility dispersion strategy
Investors who buy options of firms that are more prone to heterogeneity in beliefs are compensated in equilibrium for holding this risk. Volatility risk premia of individual and index options represent compensation for the priced disagreement risk.
Hence, in the cross-section of options, the volatility risk premium depends on the size of the belief heterogeneity of this particular firm and the business cycle indicator. Trading vehicles are options on stocks from this index and also options on the index itself. Each month, investor sorts stocks into quintiles based on the size of belief disagreement.
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This means that every time you visit this website you will need to enable or disable cookies again. Back to list of strategies. Get Quantpedia Premium or Pro. Get Premium or Pro. Markets Traded. Backtest period from source paper. Confidence in anomaly's validity. Indicative Performance. Notes to Confidence in Anomaly's Validity.
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Notes to Indicative Performance. Period of Rebalancing.
Relative Volatility and Dispersion Trading
Estimated Volatility. Notes to Period of Rebalancing. Notes to Estimated Volatility. Number of Traded Instruments. Maximum Drawdown. Notes to Number of Traded Instruments. LFIS has a symbiotic relationship with banks and earns some reward for helping them to deal with their regulatory and capital adequacy constraints, within the structure of the strategy. These derivative products may sound rather exotic and complicated, but complexity is mostly on the bank side, and most OTC products — all of which are transparent, standardised, liquid and collateralised — were developed to produce a pure and straightforward exposure to implied parameters.
The Greeks of options move around with the price of the underlying. Options require regular delta hedging and rebalancing in order to monetise realised volatility, and even then, the payoff is somewhat unpredictable and strongly path-dependent. There are scenarios under which a strategy of long delta hedged options could lose money, even if there are bursts of higher volatility and even if the realised volatility is above the implied volatility. The situation becomes even more complicated for vanilla dispersion trades which involve multiple legs and path-dependencies.
These instruments can entail some degree of valuation subjectivity. A more granular volatility surface allows for more accurate pricing, adapting trading to pinpoint the perfect instrument for each trade. Sophisticated pricing is also needed to match, and sometimes challenge, counterparty pricing, which might be too high or too low.
Trading longer maturity instruments increases model risk and places a further premium on being accurate on everything from plain vanilla to multi-asset derivatives. The risk systems are also used to manage exposures to bespoke or historical market scenarios, as well as the standard Greeks including delta, vega, gamma, theta, dividends, rates, and credit which are kept within preset ranges.
One core trade type is a long equity dispersion structure, which profits from declines in correlation between equities. Viewing the two legs separately, this trade is short index realised volatility and long single stock realised volatility. Combining the exposures collapses into being short realised correlation or being long dispersion. Academic empirical studies eg Driessen et al , Bakshi and Kapadia suggest that the gap between implied and realised volatility is much larger on equity indices around 3.
Historical back-tests therefore suggest that a simple rule-based strategy would have earned some risk premium though there are differences of opinion over how to account for transaction costs and it could have seen some deep drawdowns.
LFIS is seeking to build on this basic foundation by taking a more sophisticated approach to the selection of instruments, as aforementioned, and also to trade construction and timing. Some managers trade equity dispersion in both directions on a mean reversion basis, but we only structure the trade in one direction, going short index volatility and long single stock volatility. This means we are always long idiosyncratic risk such as takeovers when we have the trade on. Additionally, while some managers will sell more index volatility than their exposure to single stock volatility, we size the two sides on a vega-neutral basis so that there is a long convexity bias.
The intuitive rationale for implied premia persisting is more based on structural and flow issues than on behavioural finance biases that underly other types of premia. For instance, Le Her views flows as creating structural biases and inefficiencies that work in favour of the dispersion strategy. Specific flows can be linked to certain investor patterns, hedging by banks, insurance companies, commodity producers etc, and regulatory constraints.
The equity strategies are expected to have very low or zero correlation to equities. Other trade types can be within or between asset classes. For instance, gold volatility might be traded against silver volatility, or equity market volatility could be traded against associated currency volatility. The fund generally aims for longer holding periods in order to reduce transaction costs. If LFIS needed to exit trades prior to maturity, he indicates a timeframe of a day and a week, for an indicative cost of around a few percentage points of NAV.
The strategy is designed to profit during both high or rising volatility climates, and during low or falling volatility regimes, but in practice certain regimes can be more conducive than others.