The Summer of the Variance Future

It's a good day for the vol guys. A really, really good day.

On July 22, 2024, CBOE announced that it would be launching S&P 500 Variance Futures. To most people, and even to some market professionals, this is a snoozer headline — however, if you’re in the option volatility space, heck, if you’ve even touched an SPX contract before — this is a major deal.

So, naturally, we’ll be taking a dive into what these are, why they’re useful now, and of course, how we can profitably trade them.

Without further ado, let’s get right into it.

What Even Is This Thing?

Before you can understand the variance future, you first have to understand the variance swap.

If you’ve never heard of a variance swap, we don’t blame you. It is such an esoteric product that it is almost exclusively traded over-the-phone at major investment banks. Go ahead, try to find even just a price for one or any historical trade, we challenge you — that’s how under wraps it is.

Nevertheless, at its core, a variance swap is a contract whose PnL is based purely on realized volatility. To better understand this, let’s walk through an example:

Scenario: Currently, the market expects the S&P 500 to move up or down by 5% in the next 30 days.

1. A trader at a major investment bank calls you and offers a variance swap that matures in 30 days, with a strike value of 5% (the market implied volatility).

2. If realized volatility for the S&P 500 in 30 days is higher than 5%, you make a profit — if it’s less than that, you take a loss.

See? Simple — a pure and efficient way of making a bet on just volatility. What makes swaps so efficient is that the settlement values are purely formulaic, so there’s no slippage due to hedging costs, tracking errors, or anything of the like. This example is a bit of an over-simplification, but it captures the big-picture idea of a variance swap.

Currently, the only way to replicate a trade like this is through continuous delta-hedging. Let’s look deeper into that:

Scenario: The market currently implies that Chewy, Inc. (NYSE: CHWY) will move up or down by 10% in the next 7 days

1. You think that this is overstated and the real number is likely to be ~5%.

2. To make a bet and capture this difference (IV - RV), you:

   1. First, sell an at-the-money straddle

      1. This establishes delta-neutrality which leaves the position’s PnL most exposed to vega, or in other words, changes in volatility.

   2. As the stock price moves, you continuously hedge the position by buying or selling shares of CHWY.

   3. At expiration, if CHWY’s stock has moved less than 10%, the options you sold can be bought back at minimal value and you pocket the difference.

      1. If it moved more than that, you’d have to buy back the options at a loss.

The problem with this method is that it’s an expensive and logistical nightmare (commissions, bid/ask spread, price can move faster than you can hedge, etc.).

Thankfully, it’s going to be a lot easier now:

Putting The Variance Future To Work

As you can guess, the coming variance future will essentially be an accessible way of trading an SPX variance swap.

There are a lot of nuances like it being quoted in variance points and the settlement value being annualized, but the core idea is that there’ll now be a way to trade purely realized volatility.

This creates a potentially interesting options trade.

For the past few months, we’ve been selling one-sided volatility on the SPX:

Selling Volatility The RIGHT Way. [Code Included]

This has continued to be an extremely profitable operation even as recent volatility has picked up, with our trend-following component continuing to provide an edge.

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By the way, join us over at The Quant’s Playbook’s Discord! 😄 Here, you can talk with other quants and ask any questions you may have regarding strategies, code, brokers, or whatever else comes to mind!

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Circling back — if we now have this method of getting easy exposure to realized volatility, we can potentially use this as a hedge on a pure short volatility play.

To see this, let’s walk through an example:

1. Assume we are short an iron condor that pays off if SPX doesn’t move up or down by more than 10% in one quarter.

   1. We cannot use current VIX futures to hedge since in the event of a, say, 20% rally, it is highly likely that VIX futures will still go down despite realized volatility going up.

2. If the current market implied volatility is less than 10%, we can buy a variance future of a similar duration that will generate a profit if our main risk factor, realized volatility, goes up.

   1. The initial price of the variance future will be close to that 10% implied vol, so the base/best case scenario is that at expiration, realized vol stays <= 10% and we collect the full premium of the iron condor with a slight loss / flat PnL on the variance future.

   2. The worst case scenario is that realized vol increases above 10%, we generate a profit on the variance future and take a loss on one leg of the iron condor.

Hedging an iron condor with a future has the impact of reducing the theoretical max loss, so if hedged, we can potentially increase the leverage substantially since we’d have such a perfect hedge.

Further, because the futures product will have numerous expiration dates, we can routinely run the proposed strategy to build a long-term short vol operation.

So, this could definitely, definitely be interesting.

Final Thoughts

For the past few weeks, we’ve been attacking the drawing board looking for ways to boost and improve our existing strategies. To quickly recap, we are currently running 2 strategies: our machine learning based prediction strategy and our short vol operation. This process included testing different hedging techniques, different model types, regime filtering, fee optimization(s), and all manners of improvements.

We realized that while it’s good to try improving your strategies, there does come a point of diminishing returns. Often, we found that the default and most simple implementations proved to be the most effective.

As a result, we’ll be getting back to looking for new strategies and new market effects, while just letting those in production run. This will help move the needle towards the ultimate goal of a large portfolio of strategies in parallel, so we’re optimistic about the new areas we’ll be exploring in the coming weeks.

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Happy trading! 😄

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Vega Research Group