Volatility trading is among the most complex arenas in the market today, requiring that firms have the know-how to accurately price assets, to anticipate fast-paced changes to prices, and to react quickly when conditions shift.
It also requires the quantitative skills and technology infrastructure necessary to stay in step with the derivatives market, where a price change to a single stock or future can trigger thousands of alterations to options positions. Quantitative volatility trading uses algorithms to seek out and leverage changes in volatility. This often includes a blend of market making and opportunistic taking strategies. But without the ability to react instantly and scale efficiently to tens of thousands of contracts, alpha opportunities can evaporate and the risks of catastrophic losses can be unmanageable.
Firms with expansive engineering budgets have responded to these challenges with purpose-built hardware trading platforms that execute trading strategies in under a microsecond. The rare skillsets and high costs required to build such systems have constrained the scope of market-making and proprietary trading in derivatives by many major firms and created a barrier to new entrants. Exegy’s Xero Volatility Trading Engine (VTE) destroys those barriers with a turnkey product that delivers industry-leading speed at a fraction of the cost of internal development and maintenance.
Institutional Volatility Trading: An Introduction
Volatility traders develop strategies that play upon the swing of prices away from the mean and then back towards it. At an institutional level, this can be done to hedge a firm’s exposure or to identify and leverage situations in which volatility risk is mispriced. In most cases, volatility traders aren’t interested in the direction of price changes but seek to profit from correctly anticipating the magnitude of those changes.
Volatility strategies are based on trading derivatives, often in sophisticated complex orders that incorporate simultaneous combinations of calls and puts.
A common strategy employed is volatility arbitrage, which generally refers to attempts to leverage the difference between the implied volatility of an option and the forecasted volatility of the underlying asset. It’s a long-short strategy; if implied volatility is greater than the predicted volatility of the underlier, a trader would sell the option and buy the underlier to hedge. Conversely, if the implied volatility is less than the forecasted volatility of the underlier, the strategy would buy the option and sell the underlying security as a hedge.
Strategies may also incorporate volatility indicators, notably the Cboe’s Volatility Index (VIX). The Cboe offers options and futures based on the VIX for a variety of time horizons. Firms can also choose to access the VIX via ETFs and ETNs linked to VIX-related indices.
The nature of volatility trading magnifies its complexity. A single asset can underlie an exponential number of derivative contracts (varying in strike price and expiration). Large derivatives market makers may post tens of thousands of bids and offers at a time and are keenly sensitive to the pricing of their quotes. With prices of underlying securities changing thousands of times a second, they must manage quotes for every contract.
Meanwhile, proprietary traders are busy looking for opportunities to profit by determining which contracts are mispriced and reacting quickly to capture the difference relative to its fair value or immediate future value.
Regardless of which type of market participant is pursuing a volatility strategy, automation and high-volume trading capacity are essential to keep up with the rapid-fire price changes on the options and futures markets—a market sector that increases in volume and complexity every year.
On the CME, average daily volume (ADV) has increased over tenfold in the past two decades, setting record after record. The COVID-triggered volatility of 2020 led to a record monthly high in March of 32.1 million contracts.
Smaller spikes of 19 million plus in November 2020 and January 2021 (likely related to election uncertainty and the GameStop trading frenzy) underlined the potential for a continued climb in derivatives volumes—and the resulting strain on trading infrastructure that must keep up with it.
The Evolving Volatility Trading Market
As a result of this pressure, only firms with the most sophisticated low-latency technology have been able to thrive in this space. Even large firms have ceded the field to companies who have developed proprietary technology with the computing power to track the fair value of thousands of derivatives contracts.
The high cost, long timeframe, and technical risk of successfully developing a purpose-built hardware platform for volatility trading has been prohibitive for smaller firms and new entrants. In response, some firms have been shut out of this market entirely, whole others choose to pursue defensive strategies with wider (and therefore less risky) spreads that significantly reduce trading opportunities. However, as global hedge funds expand their search for strategies to deploy capital, entering (or re-entering) the competitive volatility trading space may become more attractive.
Introducing Xero VTE
With the introduction of the Xero Volatility Trading Engine (VTE), Exegy is opening this playing field—and potentially changing the game entirely. This turnkey appliance automates volatility trading strategies and optimizes local latency with tick-to-trade speeds as low as 120 nanoseconds. It provides a comprehensive suite of algorithms for mass quoting, aggressing, and canceling with standard interfaces that allow users to keep proprietary strategies and models secret.
At a fraction of the cost of internal development, firms can immediately buy a vendor-supported product with speeds equal to or better than the platforms developed by the most technologically advanced firms. New entrants in the volatility trading arena can focus their resources on sustainably differentiating themselves through better strategies, proprietary pricing models, and predictive signals, which they can keep secure because of Xero’s scalable configuration.
Exegy’s affordable subscription model scales efficiently to accommodate firms that trade a narrow range of products to market makers that quote on every contract of every market. Our team will help you install, integrate, and configure your deployment of Xero VTE based on your own strategies and infrastructure needs.
From the start, Exegy’s mission has been to help clients trade better and more profitably, by democratizing cutting-edge technology such as our FPGA-based Exegy Ticker Plant and AI-powered Signum trading signals. Xero is the latest evolution in this mission, allowing firms to enter some of the most lucrative markets in the world, competing with the largest firms while making a fraction of their infrastructure investment.
In coming installments, we’ll discuss the major factors in play in the volatility market, including the maturing of this market and the impact of retail investing on options volume.