Multi-Asset Volatility Arbitrage (Trading Strategy)
Though less understood than traditional directional trading strategies, multi-asset volatility arbitrage (MAVA) involves harnessing profiting from volatility in the markets.
At its core, multi-asset volatility arbitrage is a strategy that relies on the volatility differentials of various asset classes.
Below we look into the details of multi-asset volatility arbitrage, its benefits, risks, and how traders use it to profit from market discrepancies.
Key Takeaways – Multi-Asset Volatility Arbitrage
- Volatility in financial markets can present both opportunities and risks for traders.
- Multi-asset volatility arbitrage is a sophisticated trading strategy that exploits price differentials arising from varying levels of volatility across different asset classes.
- This strategy offers potential benefits such as high returns and portfolio diversification but also carries risks, including the possibility of price differentials not reverting to their mean as expected.
Understanding Volatility
In the realm of finance, volatility refers to the rate at which the price of an asset increases or decreases for a set of returns.
It is a statistical measure of the dispersion of returns for a given security or market index.
Typically, the higher the volatility, the riskier the investment in that particular asset.
Volatility can be a trader’s friend or foe, as it can lead to losses as well as gains.
What is Multi-Asset Volatility Arbitrage?
Multi-asset volatility arbitrage is a sophisticated trading strategy employed primarily by hedge funds and institutional investors.
The fundamental concept of this strategy lies in exploiting the price differentials that occur due to the different levels of volatility across various asset classes.
These asset classes can include equities, commodities, bonds, FX, and even cryptocurrencies and other alternative assets.
In essence, traders attempt to profit from the price differences between similar assets in different markets or the same asset in the same market but with different maturities.
It’s typically deployed in a systematic way rather than on a discretionary basis.
Benefits of Multi-Asset Volatility Arbitrage
One of the key advantages of multi-asset volatility arbitrage is the potential for high returns.
Traders can benefit from the inherent inefficiencies in the market, leveraging the discrepancies between the prices of similar assets in different markets or maturities.
This strategy also provides a means of diversification, as the assets involved span across various classes.
This diversification can reduce the overall risk of the trading portfolio, providing a buffer against significant market downturns.
Risks Associated With Multi-Asset Volatility Arbitrage
The major risk in multi-asset volatility arbitrage comes from the possibility that the price differentials might not revert to their mean as expected, resulting in losses.
This strategy also requires significant expertise in analyzing and interpreting market trends and volatilities across various asset classes.
High transaction costs can also pose a risk, as frequent trades are part and parcel of this strategy.
In addition, this strategy may require a substantial capital investment to generate meaningful profits.
Implementation of Multi-Asset Volatility Arbitrage
Implementing multi-asset volatility arbitrage involves several steps.
First, traders need to identify assets with volatility discrepancies.
This involves thorough market analysis and understanding of various asset classes. It’s generally done using quantitative models.
Next, traders establish positions in these assets, taking long positions in the undervalued ones and short positions in the overvalued ones.
They then monitor these positions, waiting for the price differentials to revert to their mean.
Once this happens, traders close their positions, thus realizing their gains.
How Are Positions Put on in Multi-Asset Volatility Arbitrage?
The multi-asset volatility arbitrage approach involves various financial instruments, with options and derivatives playing a significant role due to their intrinsic connection to volatility.
Let’s break this down:
Options
Options are contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date.
An option’s value is affected by various factors, one of which is volatility.
The more volatile the underlying asset, the more valuable the option becomes because there’s a greater probability that the price will move significantly, potentially creating substantial profits for the holder.
An important concept here is implied volatility, which is the market’s forecast of a likely movement in a security’s price.
It’s often used to price options contracts: higher implied volatility results in higher option prices.
Volatility arbitrageurs would use options to profit from differences in implied volatility (from the options price) and realized volatility (from the market).
Volatility Index Options and Futures (e.g., VIX derivatives)
The CBOE Volatility Index (VIX) is a measure of the market’s expectation of future volatility.
VIX options and futures allow traders to trade volatility without having to deal with specific underlying assets.
These instruments are directly related to market volatility and can be used to create volatility arbitrage strategies.
Variance and Volatility Swaps
These are more complex derivatives that allow investors to directly trade or hedge against volatility.
A variance swap allows one to speculate on or hedge against the realized volatility of a future period.
A volatility swap, similarly, allows trading of future realized (asset) volatility against current implied volatility.
The key to multi-asset volatility arbitrage is to identify mispriced volatility across these instruments in different markets and then to construct a portfolio to take advantage of these pricing discrepancies while minimizing exposure to other risks.
This requires sophisticated modeling techniques, rigorous risk management, and often involves a significant amount of leverage.
Related
FAQs – Multi-Asset Volatility Arbitrage
What is Multi-Asset Volatility Arbitrage (MAVA)?
MAVA is a financial trading strategy that seeks to exploit differences in implied and realized volatility across different asset classes.
This strategy involves buying or selling options or futures contracts on multiple asset types (like equities, commodities, currencies, etc.) with differing volatilities.
The idea is to profit from the discrepancies between the forecasted (implied) and the actual (realized) market volatility.
What are Implied Volatility and Realized Volatility?
Implied volatility is a metric that reflects the market’s forecast of a likely movement in a security’s price.
It is derived from the price of an option and is an important part of option pricing models like Black-Scholes.
Realized volatility, on the other hand, is the actual observed volatility of an asset over a specified period.
It is calculated using historical price data and is often considered the true measure of an asset’s volatility.
The main difference between the two lies in their derivation:
- implied volatility is forward-looking and derived from market prices of options, whereas
- realized volatility is backward-looking, calculated from historical price data
How does a Multi-Asset Volatility Arbitrage strategy work?
The MAVA strategy works by exploiting the price discrepancies arising from different implied volatilities across various assets, and between implied and realized volatility of a single asset.
For example, if the implied volatility of an asset is significantly higher than the realized volatility, a trader may sell options on that asset, expecting the price will decrease to match the lower realized volatility.
Conversely, if the implied volatility is significantly lower than the realized volatility, a trader may buy options on the asset, expecting the price to increase.
The strategy extends this approach across multiple assets, allowing traders to hedge their bets and potentially increase their return relative to their risk.
What is the risk associated with Multi-Asset Volatility Arbitrage?
As with any trading strategy, MAVA carries risk.
One primary risk is that the implied volatility may not converge with the realized volatility as expected, leading to potential losses. This is often due to unforeseen market events or changes in market sentiment.
LTCM is a cautionary tale.
Also, the strategy relies heavily on sophisticated models to predict volatility. If these models are inaccurate or flawed, they can lead to poor trading decisions.
Lastly, this strategy is typically implemented using derivatives like options and futures.
These instruments can carry high risk and complexity, requiring a solid understanding of financial markets and trading.
What kind of traders typically use Multi-Asset Volatility Arbitrage?
MAVA is typically used by more sophisticated traders, including hedge funds and institutional investors.
This is because the strategy requires an advanced understanding of derivatives, pricing models, and volatility.
It also requires access to more sophisticated trading systems and risk management tools to execute trades and manage positions effectively.
How can one assess the success of a Multi-Asset Volatility Arbitrage strategy?
The success of a MAVA strategy can be measured by the profitability of the trades over time.
This includes not only raw profits but also risk-adjusted returns.
Performance is often compared to relevant benchmarks. If a MAVA strategy is consistently generating returns above a relevant benchmark (like the S&P 500 or a volatility index), it can be considered successful.
But many strategies are focused on absolute returns rather than relative performance.
It’s also important to evaluate the strategy based on its drawdowns, or periods of loss.
Even if a strategy is profitable overall, large drawdowns can indicate higher risk.
Can Multi-Asset Volatility Arbitrage be used in all market conditions?
While the strategy can theoretically be applied in any market condition, its effectiveness may vary.
In periods of high market volatility, there may be more opportunities to exploit price discrepancies.
Conversely, in periods of low volatility, such opportunities may be less frequent.
However, due to its multi-asset nature, this strategy has the potential to find arbitrage opportunities across different market conditions, as the asset classes may respond differently to various market events.
Is Multi-Asset Vol Arb Delta-Neutral?
Yes, multi-asset volatility arbitrage typically involves creating delta-neutral positions.
This strategy aims to profit from the differences in implied and realized volatilities across various assets.
By maintaining delta neutrality, traders seek to insulate the position from directional market moves, focusing instead on exploiting volatility discrepancies.
What’s the relationship between an asset’s price and its volatility?
Asset price and volatility aren’t directly related; they describe different aspects.
Price is an asset’s current market value.
Volatility, on the other hand, measures price fluctuations over time.
High volatility indicates larger price swings, suggesting higher risk but potential for higher returns.
Low volatility implies steadier prices, thus lower risk and possibly lower returns.
Note that price changes can influence volatility, but the level of volatility doesn’t predict specific price movements.
Volatility Arbitrage – How does it work? – Options Trading Lessons
Conclusion
Multi-asset volatility arbitrage can be a lucrative strategy for traders capable of understanding and exploiting market volatility across various asset classes.
The potential for high returns and diversification benefits make it an attractive option for sophisticated traders.
However, the inherent risks, requirement for substantial market expertise, and the inherently more systematic nature to it (rather than discretionary) means it’s not suitable for everyone.
Successful implementation requires thorough market analysis, a good understanding of asset volatilities, and a way to spot and exploit market inefficiencies. (Another reason why it’s generally done with a lot of computing power.)
Despite the complexity and risks, with the right approach and due diligence, multi-asset volatility arbitrage can be a rewarding trading strategy.