An Example “Options Relative Value Trading Framework”

Why does vol trading exist?

• Exists because suppliers and demanders of vol vary along term structure and geography. This can create structural distortions.
• If you are in the gears, you can understand the players and the rhythm of markets.
• Total scalability is very limited compared to outright ownership of risky assets. Scalability is in proportion to the total amount of insurance written on the risk assets which is in turn constrained by the credit in the entire system as rationed by the banking system (and manifest through prime brokerage, exchanges, and bilateral credit) since optionality is inherently levered.

Core Competencies

Identifying edge

• The Science
  Objective: Measure and nowcast what optionality is cheap and expensive globally
  
  • Harvest and clean historical and current data (Interest rates, divs, current vols, historical data)
  • Extract implied parameters: Vol, skew, kurtosis, correlations.
  • Benchmark fair
• The Art
  Objective: Portfolio Construction
  Trade expressions:
  • relative term structure
  • relative skew
  • relative implied forwards
  • carry (correlation, relative cheapness) vs distribution (percentile analysis)

Risk Management

There is alpha in buying cheap and selling expensive. But in exchange for alpha there is path, self-fulfilling behavior, and adverse selection. The antidote is risk framework designed in anticipation of adverse movements (you don’t want to be full size or worse puking/cutting risk when the trades have their best setups…and the best set-ups happen exactly when others are offsides).

Principles of risk management:

• The business works so the number 1 rule of the business is: Stay in business. Never jeopardize tomorrow for any perceived edge.
• The risk framework prioritizes survival and does not contain risk based on historical p/l but constrains position size by shocks. Often pain in a name is a reason to look to enter the trade.
• Hard risk limits: How much you can lose is determined by position size and aggressive portfolio shocks.
  • Shock examples:
    • bankruptcy for single stock
    • implied parameter shocks
    • extreme time spread shocks for commodities
  • Protocol for position reduction or exclusion
  • Path-awareness: Shocks are not only for p/l tolerance but to estimate what happens to your margin requirement as market risks grow.

Sourcing liquidity

• Relationships with banks and brokers including electronic connectivity
• Technology stack to handle effective trade life cycle from execution to clearing, to risk and p/l reporting, to accounting and compliance

Performance attribution

• TCA of electronic and voice trades
• Actionable insights based on updated lessons

Horizontal scaling

• The abstracted framework of doing many positive EV trades and managing the pooled risks is flexible and underpins all alpha trading. Its application inches out from core competency to adjacent classes of securities.
• Requires new normalizations, data, market structures, understanding new distributions, player landscape