5. Volatility Derivatives

Exchange-traded volatility derivatives offer a powerful tool for investors to hedge against market risks or speculate on changes in market volatility. This chapter explores the unique characteristics of volatility indices like the CBOE VIX and Euro Stoxx 50 Volatility Index (VSTOXX), which serve as indicators of market sentiment and expected volatility. It delves into the applications of volatility futures and options, highlighting their use in hedging against specific event risks and expressing views on future volatility changes. The chapter also examines advanced trading strategies, such as the VIX carry strategy and the curve carry strategy, which aim to capitalize on the term structure of volatility futures. These strategies involve systematically selling short-dated futures to harvest the carry or combining short positions in short-dated futures with long positions in longer-dated futures to balance risk and return. The chapter provides a detailed numerical analysis of these strategies, showcasing their historical performance and the potential for significant returns in stable market conditions. It also discusses the risks and drawbacks, such as the high rolling costs and the potential for severe drawdowns during volatility spikes. By understanding the dynamics of volatility derivatives and the strategies used to navigate them, investors can better manage portfolio risk and seize performance opportunities in a diversified portfolio.