Volatility and derivatives?

Question

When an institutional trader says to me “We have been ‘short’ volatility”, what does he mean? What instruments would he be trading to take positions against volatility? How does it work?

Spock - Yes it does and I think I understand it but may need to read it a few more times :) Great answer, thanks :)

Why is it that people who don’t understand the question insist on providing a truly meaningless answer?

Thanks Nick Z.

Answer 1

good question

let us define volatility in operational terms as the 14 day moving average of the True Range, where true range is today's high minus today's low, plus the amount of any gap between today's range and yesterday's.

long volatility means to bet that volatility will increase in the future. you do this by buying both calls and puts in the market [long straddles if the number of your puts and calls are equal].

so then you go short volatility by selling both puts and calls into the market [or short straddles, etc.]

***
since there are four or five components which together make up the price of an option and one of them is perceived volatility, if you are short [you wrote and sold] options and volatility decreases, then the value of those options decreases. you buy them back, and you've made a profit.


does this help?

Answer 2

An option is a derivative that allows you to either buy or sell an asset, but not be obligated to do so. In other words, I can buy something but can walk away from the transaction.

The payoff profile of an option is a non-linear function of the asset that you can buy or sell. At the expiration of a call option (the right to buy an asset), the option is worthless if the stock price is below the price at which you have the right to buy; however, you participate one-for-one in the upside of the stock

This non-linear relationship between the payoff of the option and the price of the asset that you can buy or sell makes the option's value dependent upon the value of the asset that you can buy or sell. (This is where I skip the complicated math.) If the expected FUTURE volatility of the stock goes up, the value of the option goes up (in almost all but an extreme case).

To be short volatility means that you are, in some sense, net short options. You may have both bought and sold options, but from the sense of your exposure to changes in the future expectation of volatility, you are net short options. (I'm really being loose in my language here, but I hope you catch my drift.)

Your institutional trader friend is net short options in a way that makes him/her money if the expectation of future volatility declines and loses money if the expectation of future volatility rises.

Answer 3

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Answer 4

There is an options index at the Chicago Board Options Exchage called VIX. VIX index measures average volatility of option prices for S&P 500 companies at CBOE. And you can buy call and put options and trade futures for this VIX index at CBOE.

Since there are no stock prices for the VIX index, the values of VIX call and put options depend only on volatility. And you can trade volatility directly by buying and selling VIX options.

Perhaps the institutional trader meant that they've bought some VIX put options.

You can find out more about the VIX index and VIX options here: http://www.cboe.com/micro/vix/VIXoptionsQRG.pdf

Answer 5

hmmm he's not trying to confuse you, there is a lot of financial jargon to understand in this industry people who deal in stocks hate volatility however when it comes to derivatives they absolutely love volatility short means the trend is falling and long means the trend is rising through the range of volatility over a period of time. devivatives are options and futures

futures are the agreed exchange on a given date in the future hence being called futures and options are the options to take up a trade that is set for the future tricky stuff and confusing thats why the proffesionals get paid so well.

next time you speak to this trader and he confuses you dont be afraid to ask for him/her to explain theres nothing wrong with not knowing the jargon!!

Answer 6

The VIX is priced on volatility, if you are short volatility you believe volatility will fall and have written a put on the VIX.

Answer 7

He is trying to confuse you with big words. Other than that, I can't answer any further because I don't know how large or diversified your portfolio is.

At this point, there is no lack of volatility in the equity markets due to the subprime credit thing. However, this doesn't translate equally to other asset classes such as the commodities.

Answer 8

Derivatives, is practically betting on the performance of certain stocks of wheteher it will go up or down for a certain amount of time alloted. It is like you are betting on the race tracks but with higher risks and higher odds and you are using your share of stocks or probably your cash.
Or just go to Vegas or the Boardwalk where the casinos are, they are similar. Or maybe when you bet on a boxing match and put your money to your favorite fighter, the principles are the same.

Answer 9

is man stable at his devices? if we get a correct answer perhaps then we can tackle "volatility"!

Answer 10

no idea