Hedge funds are increasingly turning to options on bank short volatility quantitative investment strategies (QIS) as a way to capture volatility premiums while capping potential losses, with BNP Paribas, Citi, and UBS all launching call options, according to a report by Risk.net.
This approach, which packages short volatility trades within options, allows investors to control risk by limiting their downside to the initial premium paid, thus avoiding the large losses typical of short volatility strategies during sudden market spikes.
With over $2bn in options notional invested in QIS short volatility strategies over the past year, hedge funds are betting on these structured products as a “safe” way to gain exposure to volatility premiums.
BNP Paribas, for example, employs a volatility target mechanism, which automatically reduces exposure when volatility spikes. This method protects against large drawdowns but may limit gains if volatility quickly subsides, as seen during the 5 August spike in the Cboe Vix index, which surged 180% before reversing.
Citi, however, has introduced an alternative called “timer options,” which manage exposure without triggering an automatic deleveraging response. These options come with a predetermined volatility budget, allowing investors to maintain steady exposure until that budget is depleted, offering potentially better recovery in volatile markets.
UBS and other dealers are cautious about offering options on short volatility QIS due to the complexity of managing gap risk and the pronounced left-tail risk associated with these strategies. UBS manages this risk by using diversified baskets and incorporating defensive long-volatility elements, which helped mitigate losses during the recent Vix spike.
To offset gap risk, some banks recycle residual exposure to other hedge fund counterparties through delta-hedged straddles or variance swaps, allowing them to offer more competitive pricing.
The August volatility event served as a test for both vol target and timer options. While vol target strategies automatically reduced exposure, timer options sustained participation in the recovery phase, providing better outcomes for some investors.
