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In futures trading, the risks and returns of the popular strategy of shorting volatility, in commodity futures account opening, is achieved through selling a combination of options called straddles. Shorting volatility by selling straddles can be profitable but is also full of risks.
Despite the underlying large risks, buying and selling a series of volatility-sensitive options is a commonly used method for portfolio construction. Once this investment portfolio is established, two factors will significantly influence the value of the options: the price of the underlying asset and the predicted volatility before the option's expiration. A portfolio can be built using call options and put options, making the portfolio's return highly sensitive to the volatility of the underlying asset while minimizing sensitivity to changes in the underlying asset's price. The reason traders and investors buy and sell these option combinations lies in the future expected volatility embedded in the option prices, known as implied volatility, which may differ from the actual volatility of the underlying asset. For example, the famous Long-Term Capital Management (LTCM) once constructed option portfolios on some stock indices based on the expectation that future volatility would differ from the current implied volatility.
This practice carries significant risks; however, the establishment of option portfolios is aimed at exploiting mispricing in the forecasted volatility of the underlying assets. Since these assets are less sensitive to initial prices, the risk originates from subsequent sudden changes in asset prices. In many asset markets, volatility changes are highly negatively correlated with price changes. If a short position is established in implied volatility in a particular market, a rapid decline in that market could cause a significant increase in implied volatility, drastically reducing the value of the short position. For instance, in early 1995, Barings Bank suffered substantial losses on its short positions in Nikkei Index futures volatility due to a sharp drop in the Nikkei Index.
Although theoretically other option combinations can be constructed to bet on changes in volatility, straddles remain the most commonly used today. By comparing the observable implied volatility (option prices) and expected volatility (historical data of asset prices), we find potential flaws in this operation, especially in futures account opening conditions. If the underlying asset has a positive risk premium, this flaw can be amplified. This is because if the expected return over a period exceeds the risk-free rate for the same period, the return on the underlying asset will be negatively correlated with changes in volatility. Therefore, deciding to sell straddles based on seemingly unreasonable high implied volatility compared to much lower expected volatility may itself be an irrational choice.
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