Over the past two decades the equity derivative market has evolved and matured in many ways. A key evolution was the move in focus from ever more sophisticated exotic derivatives, often providing the end holder with a “different” directional exposure, to market participants acquiring and disposing of specific equity risks. The market participants in question are a diverse mix including pension funds, insurance funds, retail funds, structured product issuers and derivative market makers. The purpose of this article is to detail a number of these specific risk factors and describe how they can be brought together to form a multi-strategy approach to generating absolute returns. The overriding aim is to build a fund that is able to produce repeatable returns which are non-directional and which are not susceptible to outsized draw-downs. A feature of the strategy is that it is inherently multi-legged, providing greater flexibility when allocating risk capital, yet the focus remains on simplicity which typically translates to liquidity.

The risk factors

Volatility
Although many users of derivatives have a market direction mindset, the most important pricing parameter to the derivative specialist is volatility. To price an option, a trader must assume a level of volatility for the underlying instruments over the life of the option. Turning this on its head, quoted option prices therefore imply an expectation as to the level of volatility over the life of the specific contract. Knowing what the market expects, i.e. what is embedded in the price, allows a view to be taken relative to this expectation. Whereas traditionally expressing a volatility view required the trading of plain vanilla options and hedging of the resulting delta risk, it is now common practice to use a simple over-the-counter (OTC) contract for difference to achieve exposure solely to the difference between implied volatility and realised volatility. In practice such a contract trades the square of volatility, variance, as such a contract can be readily hedged (replicated) using plain vanilla options. However, the principle remains that the only determinant of the contract’s terminal value is the spread between realised volatility and the initial strike.

A common complaint levelled at volatility trading is that the positive benefits of being long realised volatility are offset by long periods of negative carry. That is, typically implied volatility is greater than realised volatility resulting in a steady drip-feed of losses. Conversely the skewed nature of the return distribution makes a simplistic, continuously short volatility strategy unappealing especially as such events are highly correlated with periods of poor performance from other asset classes. The key to successfully trading volatility is to be opportunistic, to remain flexible and to employ the full range of available instruments. Although taking an outright directional view on volatility remains a key driver of returns, it is important to recognise that implied volatility has both a term structure and a cross-sectional or skew structure. So, just as it is possible in the world of fixed income to take relative positions on the curve, the same remains possible in the world of volatility. For example, a short spot volatility position (implied versus realised) can be hedged by a long forward start volatility position further along the curve.