Following a recent period of high volatility, strategies have begun to alter accordingly and market onlookers continue to predict a growth in volatility trading as the market increasingly turns its attention to the area.
A recent report from Acuiti published in July confirmed that volatility trading is gearing up for significant growth, with the sector “moving from a niche asset class to a core strategy for many firms seeking to diversify their strategies”.
Of the surveyed prop trading firms, 75% confirmed that they had seen volatility trading strategies out-perform other markets in 2022.
Acuiti explained that their findings point to firms increasingly looking to capitalise on the more frequently occurring spikes in volatility.
Speaking to The TRADE about this correlation between less predictable markets and a move towards volatility trading, Arik Reiss, former co-head of global equity derivatives research at Bank of America Merrill Lynch, stressed the fact that “volatility trading is more reliable in more variable conditions.”
He elaborated that, though volumes drop, it is in fact during those periods in which the market is more prone to something going wrong – and volatility markets are where it shows up first.
As highlighted in Acuiti’s report – which included responses from senior executives across 94 proprietary trading firms, hedge funds, banks, interdealer brokers, and futures commission merchants (FCM) that serve the derivatives market – 2022 saw a surge in interest in volatility trading from the market.
Of the surveyed respondents, 35% labelled volatility “significantly better” than other strategies, while 33% reported a “slightly better” performance.
Speaking to the driver behind the uptick in volatility strategies which led them to ‘outperform others’ in 2022, Reiss told The TRADE: “Last year was a perfect year, for volatility trading at least, because the equity market was very choppy so it was very difficult to get any traction.
“The market was just chopping in the range and you couldn’t really get traction with equity directionally so the easiest strategy last year was just selling volatility. It just wasn’t really tested very much at all and it just kept printing.”
In addition, Reiss highlighted that the most successful actors during this time moved fast, suggesting that the sooner participants twigged that the equity market was not going to pay, the sooner they could get on with trading volatility.
Elaborating further, Reiss explained: “It was just very difficult to trade directionally last year, but volatility was very well behaved and when it’s well behaved it’s easy to trade. It was a good year to lean on volatility […] this year [by comparison] is looking pretty decent for both equities and volatility. Volatility is still pretty well behaved and working quite well.”
This year’s Acuiti report found that around a third of surveyed firms not currently trading volatility products are intending to do so going forward. Furthermore, in terms of levels of interest from clients, 44% of FCMs surveyed confirmed they had seen an increase since 2020.
Kaitlin Meyer, vice president of marketing and sales at MIAX (which commissioned Acuiti’s research), said: “Market participants [continue] to look for ways to manage their risk and hedge portfolios even during times of low volatility.”
Read more: Falling European SI volumes shows traders’ changing approach to risk during volatility, survey finds
Delving into this notion and how the market has responded so far this year, which has proven less volatile than the preceding, Eric Huttman, chief executive of independent FX-as-a-Service, MillTechFX, told The TRADE that “market participants recognise the importance of not being complacent, despite the fact that in the more recent term, volatility has fallen a bit”.
He specifically highlighted the fact that the degree to which clients are hedging has demonstrably increased, rather than decreased.
Further addressing the idea that, as volatility experiences a dip, approaches to trading strategies can alter, Huttman added: “Market participants have renewed their focus on not only wanting to hedge more, but they’ve also wanted to reduce the length of tenors that they use to hedge […] Firms - not for the first time, but for the first time in a while - have woken up to counterparty risk as well.”
He added: “What they don’t want is for all of their eggs to be in one basket. Part of that catalyst was the Silicon Valley Bank default, the Credit Suisse acquisition by UBS, and the smaller regional ones like First Republic Bank and Signature Bank. Firms are wanting to know where their money is and where their exposure is.”
Further to this, Huttman explained that corporates and fund managers are seeking to hedge more, and also be more nimble through using shorter hedge windows – seeking to “spread their eggs across more baskets and have not one bank, but several banks or several liquidity providers, where they can spread their credit risk.”
Overall, it seems that the market is tuning into what a volatile market means for future strategies, with volatility trading a key talking point.
Even during market slowdowns, like that seen over summer year on year, it is an area which remains increasingly relevant and moving. Speaking to this, Reiss told The TRADE that though August is supposed to be the quietest month of the year in terms of volumes and therefore constitutes the biggest ‘lull’, it is often the case that “something triggers when everyone is looking the other way,” a notion which the market should bear in mind.