Lets talk variance
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Thank you @Same Lazy Element for taking the time to explain this to us. Very helpful to me in formulating my trades.Gosh, what was that all about?At least have the courtesy of posting porn instead of this - BDSM/spanking images are especially suitable for the options forum, fixed income is more about painful anal sex etc.
Let's bring it back to the original topic. Here is a quick overview how positioning in variance swaps effects the cash close in SPX.
- Variance swap can be replicated as a strip of options that require delta hedging. In general, hedge funds are short variance swaps to the dealers so the dealers will be short these option strips against the market.
- Most variance swaps are on SPX and have daily observations of the cash close to calculate the realized variance. That means that the dealer who is long a variance swap will have a little straddle starting at cash close yesterday and "expiring" at the cash close today.
- Assuming that the dealer is hedging, she has an outstanding short position in a vanilla option and a daily long position in a "straddle" resulting from the variance swap. As the market moves, the variance "straddle" accumulates delta from long gamma (same direction as the market, e.g. if market is selling off, it's getting shorter delta) while the outstanding options position is going to be accumulating delta in an opposite direction.
- At cash close, the variance straddle "expires" and its delta will be gone. At the same time, the vanilla option position will still have its delta. That means that the dealer has to trade the delta of the vanilla option at the cash close so he's flat for the next daily cycle. E.g. if the market went down, Var swap got short while option hedge got long - so dealer needs to sell when var swap delta disappears at the close.
- As you can see, if the market is down, dealers have to sell. If the market is up dealers have to buy. Since delta change is based on the square of the move times gamma, the bigger the day the more the dealers have to trade. These hedging flows create momentum into the close.
- Now, imagine a situation (very realistic) where var swap gamma is a meaningful portion of the ADV in SPX futures. This creates a situation where the dealers are extending the move into the cash close and there is usually a rebound from cash close to futures close.
- Could you exploit this? You can calculate the expected impact and trade momentum into the close and trade reversion from the close. The trick is figuring out what the expected flows are going to be, of course.
Thank you @Same Lazy Element i shall dissect your post now!
First off, its going to take some time to really understand your post, but i'm very glad you took some time to break this down.
Now, my knowledge is very limited, but I am learning. You said "how var-swaps effects the cash close in the SPX". So now, I didn't know this. I still don't know what it really means, but lets walk through this.
Are you saying that the variance swaps on the SPX effect the cash close, thus effecting the realized SPX volatility? Thus var-swaps effect how realized vol will actualize?
Are variance swaps like options? I know they are OTC and not available to retail, but can you trade var swaps on any underlying that's liquid? Like AAPL, AMZN var swaps?
A market-maker who is long the variance swap can offset the risk by shorting the replicating portfolio of options, and delta-hedging. They will therefore be short gamma in the options market (Fig. 108).
As described, a delta-hedger who is short options will act to increase volatility in the underlying – buying as it rallies, and selling as it sells-off. However, the action of these market makers hedging their short options will not necessarily act to increase volatility in the underlying, as the counterparties they have sold options to may be counteracting this effect by themselves hedging their long volatility positions.
However, the important difference between these two groups of hedgers is that the variance swap market-makers who are short options, must hedge only on the close to capture the close-close realised variance specified in the variance swap contract. In contrast, the hedgers who are long the options, will generally be free to choose when to delta-hedge, as they attempt to capture the true volatility of the underlying process.
Therefore, the overall effect of hedging these variance swaps need not have the effect of increasing overall market volatility, although it may if the long options positions are not being hedged (e.g. they are sold on to end-investors). However, the important point is that the hedging of long variance swap positions may act to increase close-to-close volatility, with option hedges on the close having the potential effect of magnifying daily moves.
http://sp-finance.e-monsite.com/pag...hedging/effects-of-variance-swap-hedging.html
As described, a delta-hedger who is short options will act to increase volatility in the underlying – buying as it rallies, and selling as it sells-off. However, the action of these market makers hedging their short options will not necessarily act to increase volatility in the underlying, as the counterparties they have sold options to may be counteracting this effect by themselves hedging their long volatility positions.
However, the important difference between these two groups of hedgers is that the variance swap market-makers who are short options, must hedge only on the close to capture the close-close realised variance specified in the variance swap contract. In contrast, the hedgers who are long the options, will generally be free to choose when to delta-hedge, as they attempt to capture the true volatility of the underlying process.
Therefore, the overall effect of hedging these variance swaps need not have the effect of increasing overall market volatility, although it may if the long options positions are not being hedged (e.g. they are sold on to end-investors). However, the important point is that the hedging of long variance swap positions may act to increase close-to-close volatility, with option hedges on the close having the potential effect of magnifying daily moves.
http://sp-finance.e-monsite.com/pag...hedging/effects-of-variance-swap-hedging.html
Exactly. If there is a large outstanding variance swap position in the market, dealer hedging could impact the behavior of SPX around the close. The interesting bit for a retail trader is the short-term trade opportunities that creates around the close - the actual change to daily volatility will be relatively small.
It's nearly impossible to get dealers to quote single name variance swaps, instead dealers are quoting single name volatility swaps. This is because most funds what to buy single name variance and sell S&P variance. Dealers do not like being short single name variance swaps because single names are much more prone to gaps and gaps can be very painful when holding a variance position (you don't have time to rebalance delta and get disconnected from the option strip hedge).
Can you kindly explain in layperson's language what is variance swap? What is one selling if he sells variance swap? I only sell/buy single name options.A market-maker who is long the variance swap can offset the risk by shorting the replicating portfolio of options, and delta-hedging. They will therefore be short gamma in the options market (Fig. 108).
As described, a delta-hedger who is short options will act to increase volatility in the underlying – buying as it rallies, and selling as it sells-off. However, the action of these market makers hedging their short options will not necessarily act to increase volatility in the underlying, as the counterparties they have sold options to may be counteracting this effect by themselves hedging their long volatility positions.
However, the important difference between these two groups of hedgers is that the variance swap market-makers who are short options, must hedge only on the close to capture the close-close realised variance specified in the variance swap contract. In contrast, the hedgers who are long the options, will generally be free to choose when to delta-hedge, as they attempt to capture the true volatility of the underlying process.
Therefore, the overall effect of hedging these variance swaps need not have the effect of increasing overall market volatility, although it may if the long options positions are not being hedged (e.g. they are sold on to end-investors). However, the important point is that the hedging of long variance swap positions may act to increase close-to-close volatility, with option hedges on the close having the potential effect of magnifying daily moves.
http://sp-finance.e-monsite.com/pag...hedging/effects-of-variance-swap-hedging.html
Not really. It's over my head. AFAIK it's a tool for omm to manage their book. Also, for really big traders in vol, it's a risk management tool.
From
http://quantlabs.net/academy/download/free_quant_instituitional_books_/%5BJP%20Morgan%5D%20Variance%20Swaps.pdf
From quant.stackexchange.com
"A variance swap has a cleaner exposure to volatility then the straddle. But you have to take a bit of care if you use it for hedging how you define your variance swap vega, and how you define your options book vega. I presume your question is about hedging the vega risk of an options book with varswaps."
"A variance swap can be replicated by delta-hedging a strip of options."
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