Investment Theory and Risk Management, + Website

Selling Volatility

During turbulent times, market participants face increased uncertainty and as investor sentiment crumbles, the demand for insurance rises. One gauge of the degree of perceived risk is the interest in the term structure of implied volatility as revealed in VIX futures. The intuition is that investors bid up prices of options as they compete to buy insurance that, in turn, drives up option-implied volatility embedded in the VIX. The VIX futures is the option market's forecast of volatility one month forward. If their fears are deep enough, then futures on the VIX will tend to appear to be overpriced. In that case, it may pay to sell volatility in the form of VIX swaps. That is, we would receive the spread between the VIX contract, which has a specified strike volatility and the actual volatility. For example, suppose the current volatility is 15 percent and we buy a one-month futures contract on the VIX at a 20 percent strike. If the observed volatility rises above 20 percent, then we earn the difference on a notional amount agreed upon with our counterparty. Since these are called variance swaps, the payoff to a long position is:

Thus, unless realized volatility exceeds the strike level, the long position in the contract does not pay. A short position in this contract would be the equivalent of selling volatility back to the market. This is admittedly a simple ...