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Webcast: Market Turbulence & Volatility Products - How Volatility Products Can Move Underlying Markets

Speaker: Dr Simon Acomb

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A course on this topic is available in London Time Zone, New York Time Zone and Singapore Time Zone

Webcast Agenda

  • An overview of how market participants hedge volatility products - How this impacts supply and demand in the underlying markets 
  • An introduction to Volatility Controlled Indices - How these products giving rise to sell orders in falling markets and cause a negative feedback loop 
  • Discussion of intraday delta in variance swaps - How this impacts the market close 


Learning Outcomes

  • Understand how the action of hedging a volatility product can move underlying financial markets
  • Learn how in times of market turbulence, volatility products can cause negative feedback loops, which in turn exacerbates market uncertainty
  • Understand how differences between theory and practice in the variance swap market can impact the closing prices of financial markets



1. What measure of volatility do these strategies use to decide their leverage? (Historical? Implied? Variance swap ATM? Term or window?)
A. The usual measure of volatility is a historic volatility, using a rolling window. The data can be exponentially weighted, and I have even seen one (experiment) using more sophisticated time series techniques to estimate the volatility.

2. What's the approximate size of the variance swap market? Is there a market outside the biggest indices (SPX, STOXX, etc.)?
A. Most of the variance swap market is concentrated in market indices such as SPX. However, there are still investment banks prepared to give markets in some of the more liquid individual names. What is interesting is that the market for variance swaps has spread from being predominantly equity based to be both FX and commodity markets.

3. What about ETN/ETP like VXX, XIV, SVXY, etc.? Did they have effects on underlying markets?
A. The VXX is an interesting contract. It can be replicated by a rolling strategy in VIX futures contracts; so the VXX impacts VIX futures, but not directly the underlying market. In fact it is only in periods of extreme movements in volatility that ETN such as VXX have any really value, in diversifying investment returns. In regular market conditions VXX loses money due to a “contango roll down”. Slightly better at diversifying returns in a portfolio is the VXZ contract. Both of these contracts are covered in the volatility course, and there is extensive discussion on the roles that they play in a diversified investment portfolio.

4. Thank you very much, Simon. I’m very interested in volatility controlled indices. Can you tell me how people use these indices and give some more details on why they exist?
A. There are two reasons why people use the volatility controlled indices. First of all, they are popular with structured products providers. If an investment bank wants to market a capital protected note, then the participation in the underlying will be dependent on the volatility of the underlying. By using a volatility controlled index with a low target volatility (such as 5%), the investment bank can then produce an optically attractive product with a high headline level of participation. Secondly, volatility controlled indices are useful when producing structured products for emerging markets. One of the significant risks to the product provider is changing volatility in the underlying. This can be particularly acute when the underlying has few exchange traded options. By using a volatility controlled index the product provider can limit the impact of changing volatility in the underlying and hence reduce the exposure to difficult to hedge variables.

5. Are volatility-controlled indices the same as "risk parity"?
A. Volatility controlled indices have many different names, but mostly commonly they are also called risk controlled indices.

6. So, would you say that the vol ETP debacle of February is potentially a microcosm of a larger and deeper issue, given the era of low rates and reaching for yield?
A. There are definite issues with the low rates environment, with investors creeping up the risk profile - forever in the search of increasing yield - or participation with some level of capital protection. What strikes me however, is the recurrent theme of investor forgetting to factor in market impact when constructing investment strategies.

7. Are CPPI still used as a principal protected products?
A. Yes, CPPI are still used as principal protected products. There are two ways of looking at these products. First of all, you can think of them as just simple replication products, and therefore relatively benign. Alternatively, you can think of them as products exposed to jump risk in the underlying. This makes them complex and difficult to model volatility products – the sort of thing that requires one of the more sophisticated models covered in the volatility course.

8. Are these dynamic delta hedging strategies being driven by quant funds factoring in any liquidity measures in the underlyings?
A. The strategies that I described in the webcast do not factor in any liquidity measures in the underlying. Personally, I would be much more comfortable if they did!

9. In the last example, the banks selling of their long position in variance swaps would explain the non-linearity of the correlation of these vol products?
A. The non-linearity of the relationship between volatility and the underlying has tried to be explained many times. I’m not sure if banks selling long positions in variance swaps is an explanation. All I can say is that the relationship is definitely non-linear, and that investors would benefit from realising the consequences of this non-linearity.

10. Can you please explain once again how those investors, who are short a put option act like those who are long the put option in selling the underlying when the delta hedging moves away from zero? That is, how do we get the "attractor" outcome for long put options, and the "repeller" outcome for short put options?
A. The key point is that delta hedgers, who are long options (long gamma), have to sell in a rising market and buy in a falling market. The action of this dampens volatility and gives rise to an “attractor” around the strike of the option that they are hedging. This is because this effect is most severe when an option is close to being ATM. For someone who is delta hedging a short option position the affects are reversed. The hedger has to buy in a rising market (pushing the market higher) and sell in a falling market (pushing it lower). This increases volatility and causes the option strike to act as a “repeller”. Again, this is because the impact is greatest when the option has a lot of gamma, which is when it is close to being ATM.

Thank you to those attendees who submitted their questions.

LFS offers the 'Volatility: Trading and Managing Risk' programme with Dr Simon Acomb in London, New York and Singapore.

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