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Index Variance Spreads

One use of variance swaps is to trade the spread of volatility between two indices --> 2 main categories:

 

1. Relative value volatility trades: variance of one index at unwarranted premium/discount to another index

2. "Volatility-beta" trades: long variance on higher beta index and short variance on well-correlated lower beta index

- net long volatility, particularly as vol increases

 

--> short variance leg hedges out some/all of negative carry if volatility remains at prevailing levels

--> spread trade may to some degree cancel the extra cost of IV-RV premium

 

In a low market volatility regime --> compression of volatility spreads across stocks and indices. 

Index volatilities will probably diverge in a rising volatility market --> opportunity for volatility spread trades. 

 

A volatility-beta trade does not attempt to directly measure the relative value between index volatilities. 

It attempts to get a long vol exposure, but additionally using a correlated index with lower beta to mitigate the carry. 

Indices with a low correlation between their realised volatilities are therefore not considered as a direct volatility-beta trade. 

 

ATTENTION: 

Some indices have local "regime-changes" as their composition or behaviour of the members changes. 

Example: NASDAQ 

- 2000-2001: very high volatility index realising over 50% volatility

- Dot-com bubble --> many companies in the index have "matured"

- 2005-2006: much more like other developed market indices realising 10-20% volatility

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