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Minyan Mailbag: Variance Swaps


Options are like contingent liabilities.


Hello Prof. Succo,

I'm forever trying to figure out what causes such selling (cliff dives) and conversely intense buying (take-offs) like the ones in the last few sessions.

Are these variance swaps the main cause of these dramatic movements?

So, could we see a big reversal of today this week with high confidence?

You mentioned on the buzz yesterday (below) that the SPX volatility may continue until Nov expiration:

  • Some of the selling being done here is technical in nature.

    There is a rather large position in the Street composed of what are called "variance swaps". This is a little like trading VIX futures, although it is a professional over the counter product that is much more efficient.

    Essentially, volatility funds and credit funds have bought variance swaps (long volatility) from several large brokers. The volatility funds buy them to make bets on volatility. Credit funds buy them as a correlation hedge against credit risk (as credit spreads widen, volatility tends to pick up).

    Brokers left to hedge the variance swaps must sell SPX futures as markets decline and buy them back as they rise. In essence, there is a large short volatility position in the market (above and beyond the negative gamma and high systematic leverage that I have been talking about).

    This gamma will increase into November expiration. So the SPX may continue to be volatile if just for technical reasons.

Does this mean we will be in a narrow range?

Minyan R


Options are like contingent liabilities: if certain things happen, then a liability occurs. In this case, brokers are short lots of options to funds (variance swaps). As stocks move down, those liabilities become higher and the brokers hedge that liability (having to buy stock) by selling. As the stocks move up, that liability goes away and the brokers buy back that hedge. They get paid a premium (like insurance) to take those contingent liabilities on.

This introduction of contingent liabilities into the market is called gamma (the rate of change of those liabilities). A high gamma causes technical selling and buying of greater degree.


Some other notes to think about...

In discussing further the current variance swap market with brokers, it seems the current flow is two-sided. Some broker dealers are short variance swaps to funds as I have mentioned such as volatility funds and credit funds. But there are also brokers who are long variance swaps in good size to statistical arbitrage funds for a peculiar reason, one that I find non-rational.

A statistical arbitrage hedge fund initiates positions of long and short correlated stocks, say long GM and short F, because of statistical anomalies between the spread in stock prices. These hedge funds don't look for large discrepancies per se, but can find small ones and leverage them up. It is a mean reversion strategy that uses a fair amount of leverage: trying to capture small discrepancies and leveraging those returns. It seems these hedge funds are selling variance swaps (selling volatility) to brokers thinking that a hedge: if volatility picks up in the market place, they will lose on the variance swap, but feel that the spreads between their long and short stock positions have will close due to that pick-up in volatility.

In my mind that is a rationalization. There is a chance that those spreads will close if volatility picks up, but there is also a chance that they won't (it is a coincidence relationship, not a causal one) and there is also a chance that the pick-up in volatility will be much more than the limited close in that spread. So if statistical arbitrage hedge funds are selling variance swaps against spreads in stocks (which I actually think is also a short volatility strategy), I think this a dangerous thing and in some circumstances could be "doubling their bet".

I think that most hedge fund strategies, new closed end strategies, mutual fund strategies, and the macro environment itself through coordinated monetary policy are in nature "short volatility". We live in an economic world where real interest rates are negative and everyone is starved for yield. This creates an almost irresistible drive to take on more risk, which is of course a way to fight deflation: a coordinated effort by central banks to force investors to take on ever more speculation and debt.

And the variance swap market is a function of that. Broker dealers who are long variance and short a basket of options to hedge that risk have short gamma to re-hedge against the no gamma of a variance swap (pure Vega). This is a complicated statement. Suffice it to say that the short term growth in variance swap notional, a growth that seems to be culminating in November expiration, is introducing a new source of short gamma into the market above what I have mentioned.

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