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Tuesday, June 03, 2014

Volatility as an Asset Class

I first heard of the concept "volatility as an asset class" in 2005.  At first, it sounded like a catchword for the sell-side to push OTC volatility products like VIX futures and derivatives and other similar products, or variance swaps.  Then came 2008.  Many OTC products crashed and burned --many supposedly protective products suffered counter-party risks, something theoreticians might ignore. 2009-2010 we saw several long-volatility only funds suffer damaging losses, by being net long volatility at a level that seemed cheap historically (and dirt cheap if put in the perspective of 2008 which was still fresh in memory). Volatility, if it is an asset, is surely something of a frivolous temper.

Is "volatility as an asset class" a myth or a hype? Maybe it is, but I believe it is a solid concept.  Unfortunately, it is also a concept that may invite a lot of misunderstanding. First of all, "an asset" implies volatility is an independent "object" that can be directly traded.  In that sense, the direct tradable products like VIX futures, VXX ETN, Variance Swaps and other OTC exotic products are such assets, but that's only a small part of the story. 

If we go one step beyond the direct tradable products as the definition of "asset", we open up to a much richer world of exchange traded options that have volatility implied in all of them.  For us as a volatility fund trading equity options, no doubt volatility is an asset class, a kind of assets with nonlinearity, convexity and strong correlation that would be most suitable for a quantitative strategy.
Options are the only asset class that entails strong nonlinearity, as compared with other delta only assets such as stocks, ETF, bonds and futures, the so-called “Delta One” products. The nonlinear payoff characteristics, or optionality, come from conditional settlement and the statistical nature of the derivative contracts.

If one looks at the VIX historical chart, one may wonder how to trade an asset like VIX futures: most of time the only way to profit is by shorting the asset, while in a few instances, the spikes in VIX can threaten to undo the entire profits from short volatility in just a matter of days.  Even though it is commonly known that market going up typically correlates with VIX going down, thus a daily beta of VIX is a strong negative number, the long term correlation between these two assets is much weaker if measured in years.  VIX futures may be a good crisis insurance vehicle, but would have a much more murky result if holding for a long term.  That is the common dilemma when volatility as a directly tradable asset class.

Nevertheless, volatility is best and richest tradable asset class, even just with simple vanilla options.  There are several aspects to this statement:  1. The complex relationship between realized volatility and implied volatility; 2. The richness in the volatility surface; 3. The high correlation between different volatility assets that breeds multitude of relative value strategies.

Relativity between realized volatility and implied volatility is the area that linearized product like VIX would miss.  Though Variance Swap can catch one linear aspect of such relativity, only directly trading options with dynamic hedging strategy can fully realize the potential.  In theory, long term realized volatility may statistically converge with implied volatility so that no arbitrage opportunity can exist.  In reality, options are all short term products, and the profit and loss of dynamic hedging is extremely path dependent in the short term.  To make it even more interesting, the Gamma effect is dominant factor in the day-to-day hedging trading.  Such convexity and path dependence would make it impossible to price an option perfectly, no matter how sophisticate a model can be.  Such challenge presents a great trading opportunity for quantitative strategy.

The volatility surface is an area rich in academic research but lack of conclusive theory to fully describe and predict the changes.  Uncertainty in Vol Surface models, path dependence and convexity, are not the only complexity: the different rate of changes in first order derivatives.  Gamma, Vanna, Charm, etc. are not just fancy Greeks designed to scare the first year associates, but part of the risk management matrix that would determine the profits.  It is no longer a simple question of “long vol” or “short vol”.  You can have a short vol strategy without losing the convexity, or vice versa.

The correlation of volatility among individual equity names is generally stronger than the correlation in their prices.  A relative value portfolio concentrated in volatility assets is a popular way of profiting from such correlation.  Vega can be considered as a cross-asset inventory that can be managed in a portfolio. Portfolio optimization is no longer just an academic tool that just focuses on historical correlation, but a practical day-to-day operation that involves multitude of risk dimension.

As a volatility fund manager, we believe the concept of "volatility as an asset class" is not a novel marketing concept.  Such an asset class has the most versatile characteristics in nonlinear payoff, with very large set of tradable products in exchange traded options and equity market for the quantitative relationship to play out.

 Derek Wang, CEO, Bell Curve Capital LP - dwang at

Monday, June 02, 2014

A Very Visible Hand

Last December when then Fed Chairman Bernanke announced the first tapering of the QE by reducing the monthly purchase of 85 billion in government securities by 10 billion per month, the following historical event immediately came into my mind: mid-2004, when the Fed started exiting the “extremely low” rate (1%) program that was designed to help the equity market after the internet bubble burst, and the September 11 attack.  Once the tightening started, the Fed acted like clockwork by raising the rate exactly 25 bps in every FOMC meeting, 17 times in a row, until the rate reached the “normal” level of 5.25%.  See Figure 1.

My prediction drawn from this event?  The fed will do exactly the same thing this time, tapering by 10bn in each meeting until totally exiting the QE program.  Any deviation from such a clockwork pace will cause disruption or even turmoil in the market with the public second-guessing the intention of the Fed.

So far, we are right on the money – the two FOMC meetings after the initial December taper did exactly 10 billion each time.  Investors should hope that Yellen does not venture off course here.

Figure 1.  Fed fund rate from 2003 to 2008.

Since 2000, the Fed has been playing a bigger and bigger role in the global markets, especially the equity market.  Investors chew on every single word in the FOMC minutes.  The “full employment” mandate and the association of interest rate with employment rate – a theory that somehow became an academic orthodoxy and undisputed truth   encourage the Fed to wield the Fed Fund Rate as a universal weapon on solving any economic problem.

Look at the Fed Fund Rate history since 1989 (Figure 2), which was the beginning of this bull run that lasted over 20 years, the “norm” of rate was around 5% -- which makes the recent near 0% rate period so extraordinary in this historical perspective.  The visible and powerful hand of the Fed, with the short term rate as the main weapon (and together with its unlimited balance sheet that supports its QE programs), now becomes the most important macro-force in the equity market that overwrites the statistical aspect of the traditional invisible hands.

Figure 2.  Fed fund rate from 1989 to 2014.

Whether one agrees with the Fed’s policy or not, the powerful visible hand of the Fed should be the most important factor for market participants like us to consider.  “Don’t fight the Fed!” that’s the financial analogy of Buckminster Fuller’s “Don’t fight forces, use them”.  Several observations can be drawn here: 1.  Correlation in the market will continue to be high as long as Fed is the main driving force (even though the breakdown of some high momentum stocks in recent days was a slight deviation of this trend);  2.  Volatility will remain low, with intermittent spikes, caused by trivial things such as Yellen’s slip during a speech; 3.  The interest rate is abnormally low, but sooner or later, there will be a reversion to normal interest rate regime.

 Derek Wang, CEO, Bell Curve Capital LP - dwang at

2013: A Year of Simplicity (Again!)

Last year at this time, I summarized that 2012 was a year of simplicity. Sophisticated strategies fared much worse than simple buy-and-hold. 2013 turns out that the same statement can be repeated, except in bold: simple buy-and-hold in S&P gives you 30% return. Try coming up with a strategy to beat that.

Last year, we saw positive correlation for stocks, bonds and gold, but this year it is all about equities, while bonds ended down, gold crashed into bear territory. Looking back, there is a simple reason for such simplicity of good returns for equities: the Fed's powerful printing machine is the engine that pulls up the equity market. If we learned anything, we should have realized early in 2013 that such force is usually slow moving, thus it is a definite driver to define a trend, which is up. Translated into volatility, the trend is down. We witnessed in December another 1 for 4 reverse split of VXX.

BellCurve's meager 10% returns (before fees) for the year is a disappointment, comparing with general market. However, typical criticism of hedge funds of "not long enough" last year didn't apply to us. We have been always maintaining market neutral in our book, including during all previous near 3 years which we clocked around 20% returns each year (before fees).

A few lessons learned from our under-performance. First, with the prolific weekly option products available out there, we ended up trading a lot of such products, without keenly aware one major pitfall: in these near term options, Theta overtakes Vega, and to trade these options successfully without taking on a lot of risk (theta selling is not our strategy); forecasting movements (or the lack of) is the key. Even though we trade volatility, we should realize that stock movements are hard to predict, and probably futile trying to predict that. Forecast movement is probably even harder than predicting the direction of stocks, the latter can translate into much easier trading ideas if successful.
If we are not predicting the movement, what does our vol model do? We should first realize any model is limited, and our model is best used as a fair value baseline. If it can predict anything, it is the future implied vol level, not the future movements (or realized volatility). In this area, stock movement is the job of risk management, where we would be projecting the possibilities of stock movement, but not making any prediction.

Second lesson: beware of macro thematic investment idea. Yes, taking a view of the market, especially with a story to tell, is quite fashionable. But putting the money to work based on a theme is not a good idea for our size -- unless we have too much money seeking too few ideas. 2013 had a few macro themes that occupied the financial media airway throughout the year: QE3, Debt ceiling, government shutdown, QE tapering talk, etc. Overall we are not doing too bad in handling these macro events, and we didn't put in too much capital in this area (except for a few macro ETF like SPY). But it is a pitfall we need to be careful about. Our strength lies in discovering relative values on the volatility surface, or, mispricing opportunities that can be realized through time. For example, in December 2012, Goldman made a correct prediction that gold would be down substantially in 2013. While we do not pay particular attention to such a theme throughout the year, GLD turned out to be one of the best return names for us, by trading the vol surface reaction and skew throughout the year. A theme is an absolute idea, which is speculative at best in the direction. How well a theme can be translated into volatility is even more remote.

Just like stock movement forecasting, macro theme is an important risk management measure, but a bad trading idea generator.

We had a great year in applying our execution platform. We have set up several FIX engines and have become the first user for some option algo service providers. Now we are at a point of ramping up more volume in both the electronic channel and institutional flow, development of more proprietary automatic or human facilitated order generated algo, and trade more nimbly, with more liquidity providing trades.

BellCurve is becoming a powerful trading engine, with multiple trading venues connected smoothly and effectively into the platform. We are at a good timing, while on one hand, electronic trading in option market is stepping up, on the other, Volcker rule would eventually encourage and push buy-side firms like us to be more active in participating in the liquidity functions of the derivative market.

I see a great year ahead for us.

 Derek Wang, CEO, Bell Curve Capital LP - dwang at

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