Towards a Theory of Volatility Trading

Introduction ffl Three methods have evolved for trading vol: 1. static positions in options eg. straddles 2. delta-hedged option positions 3. volatility swaps ffl The purpose of this talk is to explore the advantages and disadvantages of each approach. ffl I'll show how the first two methods can be combined to create the third. ffl I'll also show the link between some "exotic" volatility swaps and some recent work by Dupire[3] and Derman, Kani, and Kamal[2]. Part I Static Positions in Options Trading Vol via Static Positions in Options ffl The classic position for trading vol is an at-the-money straddle. ffl Unfortunately, the position loses sensitivity to vol as the…