From the November 01, 2010 issue of Futures Magazine • Subscribe!

Making equity index volatility work for you

Equity volatility short positions are employed mainly in the index space, rather than on single stocks. This strategy tends to be more profitable because, empirically, index volatility often appears to be more expensive. But is there a reliable indicator for the overvaluation of index relative to single-stock volatility? How could a possible mispricing be exploited most efficiently?

With respect to those issues, the implied correlation should guide the investor in his investment decision process. Market participants, for example, may follow the Chicago Board Options Exchange’s (CBOE) S&P 500 Implied Correlation Index. In July 2009, CBOE introduced this index to measure the expected average co-movement of the S&P 500 index components. Investors, however, are not restricted to the American market as option liquidity in Europe, as well as Asia, has increased substantially and thereby now offers good investment alternatives.

Overseas opportunity

When looking at the attractiveness of short volatility positions for three different markets, the Dow Jones Industrial Average, the Euro Stoxx 50 and the Hang Seng index, a comparison of implied volatility versus subsequently realized volatility shows that the Hang Seng offers the best opportunities. The difference of short-term implied to realized volatility since 2008 for the Hang Seng index displays the greatest overvaluation of around two volatility points on average. Due to high realized volatility in the same time period, the Euro Stoxx and Dow Jones reveal a negative spread of -1 and -2 volatility points, respectively.

At this stage, a look into the details of this obvious inefficiency in Hang Seng volatility pricing may be helpful to figure out the best way to profit. We should seek to determine whether the overpriced volatility of the single member stocks or the overpriced implied correlation is the reason for an overvalued implied index volatility.

The latter case would indicate that index volatility often is overvalued not only in comparison to its realized volatility but also versus single-stock volatilities. A closer look at the different indexes reveals that the difference in implied to realized correlation for the Hang Seng index is highest with around 0.1 correlation points on average since 2008 in contrast to only 0.01 and 0.03 for the Dow Jones and the Euro Stoxx 50. Overvaluation is usually quite stable except for times of financial turmoil, as in mid-2008 when realized correlation increased dramatically as equity markets were falling (see "Implied versus realized," below).

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There are two ways for a trader to profit from this insight: One is selling index volatility. This could be done through a covered call writing strategy or selling (ideally delta-hedged) plain vanilla index options. Because of usually overvalued implied correlation, the strategy should earn higher profits if implemented solely with indexes instead of single stocks. The second way is by taking a short correlation position through a dispersion strategy. This solution is less sensitive to changes in volatility movements. Different implementation alternatives exist. In an initial delta-neutral strategy, the investor would take a short position in index volatility and an offsetting long position in the index members’ volatilities.

The advantage of a dispersion strategy over a simple volatility short strategy is that it is neutral to volatility valuation so that the profit and loss depends only on the realized correlation. In contrast, even if the expectation of an overvalued correlation proves to be correct, the short volatility strategy can still lose money. If the single-stock volatilities are strongly undervalued, the index volatility still can be too cheap despite expensive correlation.

A market analysis shows that inefficiencies are most significant for the Hang Seng and even persistent in times of financial turmoil, making this market most suitable for such a strategy. Furthermore, overvaluation of correlation is more persistent in different market environments than mispricing of volatility, which makes a dispersion strategy the best way to profit constantly.

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