2.4.3 Hedging Volatility Risk

Another popular strategy is to trade volatility. Remember that, for an option, the volatility and the price are essentially two ways to represent the same thing. So a contract with an IV that is larger than future expected volatility is overpriced, and IV lower than expected future volatility is underpriced. In general, volatility is mean reverting, or cyclical, and so many people wish to trade volatility while being insensitive to price. Conveniently, most complex volatility positions can be recreated using bonds, futures, and a basket of calls and puts on the underlying, and so one can create a position that is sensitive to volatility and not to price. This is known as a synthetic variance swap, and is the basis for the calculation of the VIX index.

Although it is difficult for the individual trader to create their own synthetic variance swap using options, it is still relatively easy to gain exposure to volatility, although it will inevitably come with some price exposure as well. The simplest way to get volatility exposure is to trade contracts that have high vega and low delta, which are far out of the money options. For example, one can buy a heavily shorted put contract on the SPX with a delta of 0.2 that is over 10% out of the money, and sell the put on a spike in IV for a profit, even though the option never actually had a great chance of going in the money by expiration.

This presents a risk for the market maker, who in this situation would be short puts and at risk to lose well over 100% of their position. A delta hedge is not an ideal hedge, as fast changes in vol would not be well captured by dynamic delta hedging, and still exposes the market maker to significant vega risk. The market maker then must turn to volatility products to hedge their vega exposure, such as VIX futures and VIX options. The VIX index options are generally too small of a market to use as a hedging tool, and so VIX futures are the primary vehicle for volatility hedging. Because of this, VIX index options tend to be the swamped out by the SPX and VIX futures markets, and so their pricing is often far out of equilibrium with those markets.

At this point it’s instructive to return to 0 days to expiration options on the SPX. One of the reasons that market makers like these contracts, is that most of the 0dtes trades are sold to the market maker. In contrast, most of the long position on puts is on farther dated contracts, and so market makers can use the short 0dtes to balance their vega in the intraday. There is actually an excellent example of this strategy breaking down on August 5th, 2024, when VIX climbed to nearly 70 in early morning trading from the mid 20’s the night before. Before 0dte options began trading in large quantities at open, market makers had significant unhedged short vega on their books, and were unwilling to sell more long puts until their vega hedge could be restored by 0dte short puts. Thus, the VIX spiked not because people were paying for 70 vol, but because market makers were unwilling to sell puts for less. The market, however momentarily, failed. Once 0dte sold puts came through, the market makers could restore their vega hedge and begin to sell long puts once again. Knowing the weaknesses of the volatility trading strategies can create mispricing events like the one described above that can be capitalized upon.