Friday, December 03, 2004

Comments on volatility

The comments below are from a practitioner in quant finance. I find his explanation of why implied vol is so low to be persuasive. The "technical" cause he mentions (people writing a lot of covered calls) leads to skew - asymmetry of the implied prob. dist., with upward moves of the spot less probable than downward. I'm a bit confused about whether this affects the relation between implied and realized vol - it depends on why the calls are being sold. BTW, I also recently learned that one can directly trade realized vol through CBOE variance futures.

I speak to volatility brokers on a daily basis, and whilst their opinions can vary considerably in detail, they seem to have generally the same explanation as to why market volatility has been going down over the last 18-24 months.

On the fundamental side, corporate deleveraging has caused a drop in vol. if you view a company as a leveraged series of cashflows, where cashflows are representative of net earnings, then balance sheet deleveraging means that the magnification of perceived earnings volatility should decrease. in this sense credit and vol have moved together, more or less.

On the "technical" (meaning non-fundamental) side, one thing that has increased in the last few years has been corporate call overwriting. that is, companies with large cross share holdings writing OTM calls on part of their holdings. the seller wants to sell the stock, but isn't particularly bothered about exact timing or the exact level, so may sell that option to the market and get paid. unicredito italiano went from an implied vol of 40% to under 15% mainly because of this effect!

for a very long time there has been call overwriting by money managers with moderate sized positions, but this has increased as well recently. contrary to popular belief by some derivatives traders and hedge fund traders, many intelligent people work in normal equity funds, and these people have learned that call overwriting can produce extremely good returns. as intelligent people they are likely to increase this activity in the future. my opinion there are too many vol traders out there who look only at statistics and think "vol was historically higher and vol reverts to the mean, therefore i should buy it". whilst many senior traders don't fall into the mean-reversion trap, more vol traders need to think about the game theory aspect of what they are doing. if everyone who delta hedges is long gamma, there will have to be an extra large volatility shock for implied vol to increase, as everyone will want to try and take profits by selling their options! and if nobody sells their options, everyone will delta hedge against market moves, as discussed, and decrease implied vol.

it is like people who play poker and only look at their own hand, just playing the statistics. they should look around them and think about what other people are likely to do, given the information available.

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