Introduction
In a Flirting With Models podcast, Benn Eifert, founder of hedge fund QVR advisors, discusses “volatility investing.” Benn outlines the fundamentals of relative value, why it works, and its applications to volatility trading. He also explains how volatility traders develop strategies, looks for trade ideas, and his worldview on the relative value volatility trader’s role in the markets. This article summarizes some of the key points in this interview with Benn Eifert.
Volatility investing is different from the average options trading strategy.
Volatility investors seek to identify features of the return distribution—such as volatility—while avoiding exposure to the direction of returns. For example, call overwriting and put writing are two common option strategies involving taking long equity positions. These strategies leave investors exposed to market movements in either direction.
The Fundamentals of Relative Value Volatility Trading
Relative value strategies involve buying cheap exposures and selling expensive exposures at the same time. This hedges out the main directional market risks that would otherwise be present in a traditional investment portfolio. In other words, this strategy allows investors to benefit from price differences between different assets while mitigating their risk exposure to changing market conditions. For example, if Visa is overpriced compared to Mastercard, a trader could take a short position in V and buy MA as a hedge. This would insulate the trader from broader market movements, isolating the relative prices between the two stocks.
In the interview, Benn gives the example of a trade where he buys options in large-cap energy stocks while selling options in small-cap energy. This opportunity was created by large funds selling calls on their large-cap energy names, driving down their prices. Finding relative value volatility trades can be difficult because market conditions are constantly changing – traders must constantly watch options prices and try to understand why dislocations (price inefficiencies) pop up. For example, writing covered calls might be extremely popular with pension funds for a couple of years before falling out of favor. A savvy investor has to understand when there is an opportunity and when it has dried up.
Why Relative Value Volatility Trading Works
Relative value volatility traders provide an important service to the market: they provide liquidity for end-users of options and redistribute risk from areas where options are in abundance to those in high demand. For example, if pension funds wish to buy puts on their investment in Mastercard, it may increase the implied volatility prices of the options. Volatility traders can sell these overpriced MA options and hedge by buying cheaper options elsewhere, perhaps on Visa or a bank stock.
This type of trading has been made possible by the need for users of options to find ways to manage their risks. Much of the supply and demand that sets the market prices of options aren’t looking at implied volatility – they’re just trying to hedge or execute a directional trading strategy.
The Star Wars Analogy
Traders often attribute returns to “risk factors” such as momentum or value in traditional investing. However, Benn uses the “Star Wars” analogy to explain relative value volatility trading. Benn first states that many users of options tend to do the same things at roughly the same time, whether that be covered call writing, collar purchasing, or other trades. Because they act like one big “herd”, their trades can push prices around until they don’t make much sense. This is what Benn describes as “a disturbance in the Force”.
In these scenarios, relative value traders supply highly demanded options or buy oversold options, restoring a balance to the forces of supply and demand. After buying the cheap options or selling the expensive options, the relative value trader tries to hedge by trading similar options closer to fair value. Because these hedges are imperfect, relative value traders are exposed to “basis risk”. However, the profits from selling the options that are too expensive (or cheap) make holding basis risk worthwhile.
Finding Good Trades
Several different investment strategies form QVR’s portfolio – each strategy is designed as a response to what options traders in the markets are doing.
For example, When a fund begins selling covered calls on a long, large-cap equity portfolio, the prices of options within that universe decrease significantly. Traders would then be able to notice (through quantitative analysis) that the prices were compressed because of fund flows rather than other factors.
By tracking these dislocations over time and assessing of each opportunity, investors can determine how aggressively to respond. Additionally, by speaking with market makers and other institutional options traders, investors can gain insight into large-scale activities in the markets that may affect prices.
Systematic or Discretionary Trading?
In the context of investing, there exists a spectrum between discretionary and systematic trading. On one end of the spectrum is discretionary, gut-feel-based investing. On the other end is fully automated trading. Most volatility managers lie somewhere between these two approaches; full automation is difficult because options aren’t linear products like stocks or futures. As a result, small mistakes can lead to big problems.
An Example of Systematic Trades Gone Bad
In 2012, as the Japanese economy struggled to recover from a long-term period of stagnation, and the Japanese stock market (the Nikkei) was performing quite poorly. Around this time, something interesting happened to the skew of Nikkei options; while most equity indices have put skew, Nikkei call options were trading at a premium compared to puts. Option prices were implying a volatile rally upwards, rather than the typical “up like an escalator, down like an elevator” dynamic of the equity markets. Many volatility traders, seeing this call skew, sold calls aggressively.
However, these traders made a large mistake; they forgot to consider the macroeconomic landscape, only focusing on historical data. Prime Minister Abe’s government enacted structural reforms and unconventional monetary policy ( “Abenomics”), which caused the Japanese equity market to experience an unexpectedly sharp rally. Those who sold call options took large losses.
Conclusion
In this interview, Benn Eifert provides insight into the world of relative value volatility trading. He describes how volatility trading differs greatly from the average (directional) options trade and how relative value traders look to restore the balance between supply and demand in the options markets. He also shows that volatility traders need a deep understanding of market participants in the option space, the skills to analyze option prices, and the smarts to realize how their analysis could be wrong. In this interview, Benn Eifert describes relative value volatility trading as a challenging, but rewarding trading strategy.
