Long Term Capital Management was both selling volatility as well as absorbing volatity in the market.
Describe how Long Term Capital Management sells volatility in the fixed income and equity option products. How can this trade lose money? How can the mortgage trade also be characterized as selling volatility?
Generally, volatility is a measure of the speed of change in the market. High volatility is equivalent to a rapidly rising or falling market while low volatility means a slower moving market. The rate at which an asset’s price fluctuates is usually determined by its popularity.
The measure of volatility can be either historical or implied. Historical volatility is where past stock movement makes up the valuation. Implied volatility is a measure of an underlying assets volatility which is reflected in an option’s pricing. Its volatility is implied by the current price of the option.
LTCM Expertise in Selling Volatility
In selling an option, LTCM has to decide on the fair premium buyers have to pay. This premium is reliant on mathematical models and ultimately various market variable inputs chosen by LTCM options constructors.
Causing Volatility while hedging
LTCM relies on dynamic hedging to reduce risk as time progress. This would partially mitigate erroneous options pricing. However, in strong market, the hedging activity caused by the option seller accentuates volatility of the underlying assets as option seller have to alter exposure of itself to the underlying asset by buying or selling the underlying or its derivatives so as to be as neutral as possible.
If LTCM perceived that market participants expect and underlying stock to exhibit high volatility going forward, LTCM would sell options at high premium. If LTCM believed that market has little volatility, LTCM would sell options at lower premium so that market participant would expect the underlying asset to exhibit low volatility going forward.
Trades Can Lose Money
It fundamentally requires LTCM commit to a forward looking opinion of the market. This premise is fundamentally not infallible. Where options premium is insufficient to cover for the market movement, interest rates, cost of funds, and dynamic hedging costs and relevant back office and support costs, LTCM could lose money in the trade.
Later part, using the VIX for S&P 500 as proxy, volatility approaches 25% while LTCM sells options with implied volatility at expectations of 20% volatility as it does not expect volatility would average 20% on a sustained basis.
Selling Volatility with Mortgage Trades
Mortgage trades require LTCM to develop an understanding of the prepayment behavior to estimate the fair value of the mortgage pools and the sensitivity of that value to interest-rate movement of mortgage buyers.
This is equivalent to deciding pricing premium for selling of options where the underlying prices at a future time have to be decided before the option is issued. In this case, LTCM has to decide the fair value to purchase the mortgage and also the underlying prepayment or refinancing decisions of the mortgage borrowers.
Volatility of the derviative and underlying interest increases when financial product moved close to borderline or beyond the border of pricing range of the options issuer. When trading options, consider what the seller intended the market direction to be. The seller of options would like to make profit from premium while remaining risk neutral.
Long Term Capital Management was selling volatility and absorbing volatility at the during period when options are valid.