Categories

Archives

Long Volatility = Shorting the Underlying

Trading Volatility is considered to be an extremely risky business by the average investor because of its complexity.
I have read many articles and opinions written by sham experts and disguised traders about trading options and volatility. Funnily enough, I found out that most of them complain about the fact that volatility trading does not work and therefore you should be using other strategies in order to have consistent profits.
Obviously, this is not true and the majority of traders and investors don’t understand the great advantage that an accurate forecasting of volatility can give. Let’s break it down.
Over the last 10 years many academic researches about volatility presented a multitude of models and every “inventor” had to fight in order to promote the reliability of his/her model against its competitors. However, put aside the debates about which model is the best, it is evident that all of them had to agree about the fact that volatility increases much more when the market drops!!!

In technical jargon, options traders use the sentence “I am long volatility” when they think that in that moment volatility is cheap and it is worth buying; but what they really mean by saying that?
In practice, buying volatility means selling the underlying asset. What? Are you crazy?

Let me be more precise. If you are an options trader and you think that volatility is cheap you are probably assuming that the estimation of volatility that you are getting is rather low (regardless if you are using the VIX, stochastic volatility models or technical volatility indicators). Since volatility is mean-reverting you are probably expecting a sharp market movement either up or down. However, since an increase in volatility usually drives the market down and an augment of its value during an up movement is more often than not a “fake head” it is easy to understand that: buying volatility is effectively shorting the underlying.

For the sake of precision, it must be said that this is not always the case and that a rise in volatility could initially welcome even a steady and robust upward movement.

Nevertheless,the last time analysts, econometricians and quantitative traders said that volatility was too cheap was before the credit crunch occurred and since then the volatility decreased to a level which is even lower than what it was during the great bull market which lately faded out.
What are you going to do then?
Will you buy volatility or short the underlying? Ooops, sorry !!!

Leave a Reply

Your email address will not be published. Required fields are marked *

Go back to top