Nov 14, 2008

The Price of Volatility !!

I recall my first attempt at running an delta-hedged options portfolio very clearly. It all started with my fascination of trying to devise quant trading strategies based on financial theory I'd read at various points.. I'd tried 2-3 strategies earlier with considerable success so I was pretty confident that this would work out as well... 
Couldn't have choosed a worse time to try the strategy - using the October 2008 contacts (the period before volatility levels went off the charts) on the NIFTY (one of the most volatile equity indices around).. The NIFTY was at around 4000 levels.. Option implied vols were up from around 30% levels to around 50%...almost at historic highs... it was just the opportunity I was waiting for. I sold an at-the-money straddle that gave me a profit band of around 10% around the strike price. 
Little did I know what lay in store for me.. and I guess this was the best way to learn.. the market collapsed.. went down 10% to 3600 in the next week.. and I sold another straddle at a lower strike to widen my profit band (read as dig a deeper grave).. I was delta hedging my portfolio perfectly.. but the losses were huge.  Couldnt figure it out too well except that implied volatility had gone up to around 80%..  
Anyway, the markets' returned to a level where I was previously making profit.  I was shocked to see that one week later (when theoretically the profit should've been higher), I was still losing money.. and a lot of it.. the only difference from a week earlier was that volatility had risen to levels of 90-100%. 
I cut all positions immediately and booked my losses (booking losses quick was another hard learned lesson from earlier experiments).. and god knows I was lucky...the markets collapsed another 50% from the levels I had booked my losses.. had I not cut my positions, I would've been seriously hit.. 
I guess I paid a very small price to understand what volatility was....and now I know why they call VIX the 'fear index' - the part of insurance cost that cannot be explained by models (and thus considered irrational) is the reflection of higher than normal uncertainty or 'fear'..

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