A systematic approach to the Sell Side's traditional customer-facing options business

1. Volatility Arbitrage & Flow Trading
The Use of Quantitative Strategies for Portfolio Hedging and Inventory Management
Contact:
David Hamilton
Phone: 917.499.7331
davidehamil@gmail.com

2. Introduction
The purpose of this overview is to demonstrate the merits of using a calculated,
systematic approach to handle client-driven trading flows.
By employing quantitative valuation methods and strategies, a Dealer can be
extremely proactive in the pricing, hedging and risk management of its
customer facilitation- an activity that is, by definition, innately reactive.
Specific topics will include:
•
Volume & order flow in the US options market.
• The basics of Flow Trading.
• A systematic approach to client flows.
•
Specific examples of a systematic approach.
2

3. US Options Market: Volume & Order Flow
The US Options Market has seen unprecedented growth over the last decade.
• Listed volumes currently average approximately 16 million contracts per
day and are traded across 12 exchanges.
• Options on ETFs have been the largest growing class in volume over recent
years (~35% of ADV). Index products, primarily SPX options and VIX
options & futures have seen the biggest increases on a risk-adjusted basis.
• 30-40% of ADV comes from the top 100 most liquid single stock options.
15 October 2013
Total Volume
Index
Contracts
% Volume
17,998,392
100.00%
2,185,534
928,517
1,114,243
12.14%
5.16%
6.19%
15,812,858
2,916,586
3,550,814
87.86%
16.20%
19.73%
Top 250 Equity
Top 100 Equity
Equities #101-250
7,807,041
6,280,238
1,526,803
43.38%
34.89%
8.48%
Remaining Equity & ETF
1,538,417
8.55%
SPX
VIX
Equity & ETF
SPY
Top 50 ETF (ex-SPY)
Source: Options Clearing Corporation.
3

4. US Options Market: Volume & Order Flow
Source: TABB Group/Hanweck Associates.
•
Approximately 70% of volume in single stock options comes from the top
100 names. 40% of volume comes from just the top 10!
•
As liquidity increases and direct access to onscreen markets becomes
cheaper and more prevalent, Customers (especially ones who are vol-savvy)
could increasingly shift their Dealer facilitation requests to less liquid
stocks (names 100 and above) and pit-traded index products (SPX, VIX).
4

5. US Options Market: Volume & Order Flow
•
The increase in VIX option volumes from 2006-present bears this out:
•
Expanding client interest and liquidity presents an opportunity for extensive
commission capture and employment of unique vol-of-vol strategies and
hedging:
2
Perfect Replication of VIX T
1
2
VIX T1  
2
T
 ST T 
pricet ln 1 
ST1 



ST
ST T 
 2
2
 pricet 
ln 1 
ln 1 
S 0 T
S0 
 T
 pricet PF 
We can buy today a PF which gives VIX2T1 at T1: buy T2 options and sell T1 options.
Source: B. Dupire, Bloomberg.
5

6. Flow Trading: the Basics
Flow Trading, by its very nature, is largely a reactive practice for liquidity
providers.
While Dealers are instrumental in deciding the price at which a given
transaction takes place, it is their Clients who initially dictate its major
components:
• Underlying Stock, ETF or Index
• Structure (outright, delta-neutral, spreads)
• Size (# of contracts/vega)
• Maturity
These criteria must be evaluated quickly to determine a level that is
competitive enough to win the trade, yet commensurate with the amount
of risk involved.
6

7. Flow Trading: the Basics
When evaluating the dynamics of each potential trade, particularly with single
stock options, Dealers are required to simultaneously consider multiple risk
factors:
• Liquidity
Should a client facilitation occur, how easily can the Dealer trade out of
or hedge the resulting position?
• Valuation Metrics
Current price/implied volatility vs. historical norms. Is a given interest
rich or cheap in terms of a Dealer’s proprietary pricing methods?
• Binary Event Risk
Is it highly probable that a one-off event (upcoming earnings,
takeover/merger, Stage 3 Biotech) will impact a given interest?
By adopting a systematic approach to pricing, hedging and risk
management, Dealers can greatly improve the speed and efficiency with
which they handle their client flows.
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8. Client Flows (Platform Overview)
Quick Hedge
Client Trade is
Flipped/Spread vs:
Client
Options
Flow
• Inventory (Flow &
Corporate)
• Layoff Clients
• EMM Desk
• Onscreen Markets
• Secondary Mkt.
(IBDs)
Dealer
Strategic Hedge
Client Trade hedged
via:
• Relative Value
Arbitrage
(stocks, ETFs)
• Volatility Index
Arbitrage (SPX, VIX –
index vol/skew vs.
vol-of-vol)
• Dispersion (stocks,
ETFs, Index)
8

9. Client Flows: a Systematic Approach
• Determine if a given interest warrants a “Quick” or “Strategic”
hedge.
Identification
Valuation &
Optimization
• “Quick” Hedge: Determine “Best Fit” solution given current
inventory, appetite of Layoff Clients, available liquidity onscreen and
Secondary Market demand from IBDs.
• “Strategic” Hedge:
- Determine valuation by simple means or multi-factor model.
- Choose strategy that provides optimal context for managing the
residual risk that would result from client facilitation.
9

10. Client Flows: a Systematic Approach
Dealer facilitation in less liquid stocks (names 100+) and ETFs presents an
opportunity for wider trading margins, but requires longer holding
periods and dynamic inventory management to realize trading profits.
Using quantitative valuation methods and strategies to price, hedge and
manage risk with lower-tier interests has multiple benefits:
• Can dramatically reduce costly residual positions
• Maximizes commission capture and trade p/l
• Keeps trading staff focused on client pricing, highly liquid stocks
(names 0-100) & ETFs and special profit opportunities.
Examples
- Relative Value Arbitrage
Determines richness/cheapness of individual stock/ETF vols using mutltifactor model with technical and fundamental inputs. Long/short portfolio of
the largest outliers is constructed and held to allow valuations to revert
towards their forecasted mean.
- Volatility Index Arbitrage & Dispersion
10

11. Relative Value Arbitrage (1 Month Maturity)
10-Year Backtested Returns, Jan 2002-Jan 2012
Average (vols x 100)
Sharpe
Stdev
2002-2011 2010-2011
0.0300
0.0151
2.2601
1.3197
0.0459
0.0395
Bin Frequency
-0.06
5
-0.04
5
-0.02
15
0
30
0.02
50
0.04
40
0.06
42
0.08
25
> 0.08
28
11

12. Relative Value Arbitrage (3 Month Maturity)
10-Year Backtested Returns, Jan 2002-Jan 2012
2002-2011 2010-2011
Average (vols x 100) 0.0283
0.0286
Sharpe
1.8259
1.9300
Stdev
0.0537
0.0513
Bin Frequency
-0.06
6
-0.04
13
-0.02
21
0
28
0.02
39
0.04
38
0.06
30
0.08
25
> 0.08
31
12