Going ‘Long Vol’ and ‘Short Vol’

When a share market investor says that they are ‘long volatility’ or ‘short volatility’, what precisely does that mean? Usually being ‘long’ or ‘short’ an asset means that you have bought it or sold it. To go long BHP you would buy BHP shares. To short BHP you would borrow BHP shares and then sell them.

But many things cannot be bought or sold. You cannot literally ‘buy’ inflation for instance, but you can still be ‘long inflation’. In this context being long something means that you have a positive exposure to it; that is, you benefit from it going up and lose if it goes down. The reverse holds if you are short. For example, Qantas is naturally short the oil price because its cash flows fall when the oil price rises. Qantas hedges its natural short position in oil with a long position in oil options contracts.

Back to share market volatility. An investor who is long the volatility of the ASX200 index has a positive exposure to volatility in the market. If during 2015 the ASX200 index proves to be more volatile than expected then the investor will profit; conversely they will lose if the ASX200 is less volatile than was expected.

Long and short volatility comes to mind because I keep hearing commentators say ‘get ready for a wild ride’ or ‘the market expects 2015 to be highly volatile’. You might think these commentators are hedging their bets by refusing to predict whether the market will rise or fall - instead they are saying that something big will happen but we don’t know what. But it is perfectly legitimate to predict high volatility without saying which way the market will move. Nontheless, people who predict high volatility could of course put their money where their mouth is by going long volatility.

A long strangle

There are many ways to do that. Here is a simple example. Let’s say you wanted to go long the volatility of the ASX200 index in 2015; meaning that you want to profit if there is a big movement in the ASX200, either up or down. The ASX200 is at 5350 today. Say you buy a Dec 2015 call on the ASX200 at 6300 for $24 and a Dec 2015 put option on the ASX200 at 4400 for $91. Thus far you are $115 out of pocket and that is where you will stay unless there is a big movement in ASX200 by 17 Dec 2015 when the options expire.

Your upside is that for every point the ASX200 goes above 6300 your call option gains a dollar. So, above 6415 your overall position is in-the-money, as shown in the graph below. Likewise, for every point the ASX200 falls below 4400 your put option gains a dollar, so below 4285 you are in-the-money. Therefore, if vol turns out to be large, you are in the money and if it is small you lose your $115. The strategy of buying a call option and buying a put option to go long volatility is called a long strangle (don?t blame me). If you wanted to short volatility you would do the opposite - write (sell) a call and write a put.

The example above is a simple one. The point is that when sophisticated investors take a view on volatility they take a position that matches that view - they go long or short vol.

Volatility implied by option prices

Note that we know how concerned the market is about ASX200 volatility because expected volatility directly determines option prices. The famous Black-Scholes equation gives us the direct link between option prices and expected volatility. We plug several variables, including the expected volatility of the share price, into the equation and out comes the ‘fair price’ of the option. We can run this in reverse by starting with the price of an option observed in the market and working backwards to get the expected volatility (called the implied volatility) used to value the option.

The implied vol of the ASX200 from the options I mentioned above is currently 15% per annum. That is not much different from the historical volatility of the ASX200.

If volatility embedded in option prices is not much higher than historical volatility of the ASX200, then what are those commentators talking about when they say ‘the market expects high volatility in 2015?’. I am not sure.