I'm about to have an interview for a global macro-type team. I'm researching some stuff on the internet about correlation derivatives and came across this in one of Goldman GIR's research notes from last year:
"long-only stock pickers, equity hedge funds or their investors (e.g. funds of hedge funds) are implicitly short correlation. They could hedge the risk of disappearing stock picking opportunities in ‘macro markets’ by buying correlation at low implied levels"
I'm having a little trouble wrapping my head around this. My understanding is that one would short correlation when the implied correlation is above the expected future correlation, and long correlation when the opposite is true. I also realize that correlation rises significantly during a crisis.
However, my question is : Why would buying stocks be the equivalent of shorting correlation - is it because you don't think that correlation (thus the risk of a financial crisis) will be as high as the rest of the market assumes?
Also, how do equity correlation derivatives work? How are they priced? Are they based on correlations between equity names in a certain index, or correlations between all the different securities in the market?
Sorry about all the noob questions- I've never been exposed to the correlation market before and would really like to learn a little more since internet searches aren't helping me.
my reading of this is not that they are "short" correlation in that they will literally directly profit if the realized correlation is lower than what is currently implied I think they mean that their business model is much more viable if correlations are low if you are a stock hedge fund and correlations are high, you are probably going to have index-like performance because all stocks are moving together but no investor is going to want to pay 2/20 for index like performance, since they could just go buy equity ETFs like SPY instead to get that kind of behavior so in essence hedge funds are hoping that correlations are low since otherwise they might lose AUM i guess what they are saying is that you could perform less like an index during high correlation times by using correlation derivatives
also note they are "implicitly" short correlation, not actually short correlation
thanks Junior- that was a really insightful take. Are correlation derivatives relatively niche and mathematically complex?
This isn't something I do, so hopefully someone with actual knowledge of the market will help correct any errors I make, but I do think I can add something to what has already been said as I've heard correlation swap pitches a few times. I'm not sure how much you understand the underlying mechanics Lily, so sorry if this is a little patronizing, but you asked about how they "work" and "pricing" so with the major caveat I'm talking out of my ass a little bit, here goes:
Correlation is something which, like other weird sounding swaps on market statistics (ex. var swaps), is priced out of large options books at banks. There is no "natural" supply of index level vol in pretty much any asset class, so options market makers (i.e. banks) sell index vol and hedge in single name vol. Single name vol tends to be cheap relative to index level vol because there is a market supply of single name vol from embedded options in converts, warrants, etc.
If you've ever tried to calculate portfolio level variance or vol, or are passingly familiar with CAPM, you should know that correlation figures prominently. Now, imagine trying to calculate the vol of the S&P 500 from the vols of each stock in the S&P 500. If you use implied vols for the index and constituents you can back out implied correlations. This is the strike for the swap. The observed value which is compared to the strike is calculated based off of average realized correlations in the typical format. Still with me?
Thus, (I have heard, I'm on the buy side) banks which make markets in options often end up implicitly very long implied correlation (i.e. the bank thinks I'd like to hedge my index vol in single name vol, I want my single name vol hedges to work well, thus I want my single name vol hedges to rise or fall with the index). One cynical reading of the GS piece you reference, like many GS pieces, is that they are trying to get someone to help them de-risk their book and get paid simultaneously by charging wide bid asks on some moderately exotic product. The sales pitch is kind of like this: "hey you over there: you're implicitly short this thing I wish I had less of. Buy some now."
I would be very curious if anyone who does this type of trading could comment. You hear a lot about index vs. constituent trades of this type in many asset classes...again, not really my area of specialty but something I find interesting...
this post is very much on point with what generally considered to be equity correlation/dispersion trading. very good summary overall.
Look once I calculated the correlation coefficient between the S&P500 and the VIX index and got -0.66 of course using different sample you will find other figures, however one thing is sure you will always get a negative number. Check the constituents of the VIX you will understand why.
Not to be a dick, but your first language isn't English or you're trolling, right bro?
There is an observed correlation between implied vols, skews and underlying asset moves, which maybe surprising if you believe Black-Scholes to be literally true, and it is quite general across all asset classes (usually, "bad" asset moves = higher implied vol. What is bad isn't the same across fx, commodities, rates, equities, etc.).
This is not the same as the correlation people are talking about (though I admit it is related in some sense) when discussing correlation swaps on equities.
As you are an overskilled self-made guru tell me why LVS, X, HAL are the most volatile on intraday basis.
(partially) Fixed that for you.
I try to answer questions people ask when I think my answer is likely to be useful to them or others. It happens that I knew somewhat more about correlation trading in equities than the others who had already posted on this thread, though I am by no means an expert. Your post about VIX vs. SPX correlation seems unlikely to be useful to anyone and has grammar bad enough that I found it vaguely confusing.
I actually don't know anything at all about why the 3 names you mentioned are "the most volatile on intraday basis". I don't even know whether or not the implicit hypothesis, which I can only guess at and included in my attempt to partially correct your post, is accurate. Let's assume for a moment that it is. Would you care to tell me why those stocks are the most volatile on the big board?
Without knowing anything about this, as I really don't deal with single name equities much, it's almost certainly some combination of random chance if they haven't been "the most volatile" for long, technical factors related to large and\or small holders needing to liquidate, and fundamentals\news flow.
Please enlighten me about the real reasons they have so much intraday vol. If you could include in your answer a discussion of why and whether the intraday vol diverges from longer time period vol that would also be great. Also very interested in knowing what basket of stocks they are the most volatile in. Thx.
Well, LVS, HAL, and X are the traded by day traders who love volatility, it is not rare to see a 1 dollar move in few minutes, needless to say that they are quite risky and quickly trigger the 5 minute count down which disable the trades for the day and lock on the losses if things had gone wrong. I did some daytrading at some prop trading firm and saw the gamblers trading those stocks, I was trading financials, JPM was quite volatile but less than LVS for instance, in the other hand BAC move by 1 cent, look at the different charts you may understand what I mean (http://www.freestockcharts.com). Recently I came through an artcile which explained why High Frequency Traders love BAC after it plummeted to 5 dollars, because it gave them more buying power and hence provide with more negative commission fees. Interstingly the C was like BAC moving by 1 cent or 2, till the reverse split happened in May 2011 and the stock was trading for 40 instead of 4, then C became even more volatile than JPM. As for the volume you may look at it on the chart but I've heard that the NYSE is not providing with reliable figures when it comes to volume.
I'll drop my two cents here, even if Market's two posts should have already shed some light, I also find him to be well versed in legalese which is the language this report seems to be written in. Goldman suggests to buy correlation when the implied is low and resell while high. If you're a hedge fund manager you'll need to improve your annual return around november (remember, fees are 2 and 20 per cent), when the correlation is high (hence everything moves in the same direction) your investors are ought to look for beefed-up performances elsewhere since you cannot guarantee (given the aforementioned scenario) a decent return by just picking stocks, selling correlation you bought is a good way to make money.
I'll use Marked to Market as an example: he is paid to pickup good stocks, from a business perspective his work is going to be much more valuable when the market is in distressed conditions and everything is chaotic, in good times he'd want to hedge his risks (customers move elsewhere because of his stockpicking not giving high enough returns) by buying cheap correlation to sell when things go bad.
What's in it for the market makers? They go long on single stocks options as opposite to indeces ones (read Marked's previous posts) and therefore cannot gain advantage from rising correlation (single stocks are slower in catching up) , when the market is awry and stuff goes bad the banks are already suffering, on top of that they cannot get any benefit from their vol trades either, deinde the need to find new customers to sell them correlation.
That's interesting. I am familiar with some research that shows stocks with either very low or very high dollar prices behave strangely.
The thing you're talking about with LVS though doesn't quite make sense to me, but as I don't "do" equities normally I may be missing something. Why should day traders be concentrated in LVS, HAL and X? It's not like a typical "day trader" (unless you're talking about HFT) can move the market for most stocks. I don't think you are talking about HFT, are you?
Here the link of the article I was talking about which relates to BAC and HFT http://finance.yahoo.com/news/why-bank-america-citigroup-080559149.html
As for traders "interested" on LVS, I was referring to amateur daytraders, basically those who move the market are the institutionals, maybe the trick is on the buying power, looking at the charts would hide the fact that a 100 shares of C today should have been compared to a 1000 shares before the reverse split. At the end of day historic volatility should be calculated, something I did on a yearly basis, but for intraday the relevant intervals are 1 minute or 2, I will get such data soon and make the calculus of the standard deviation of each one of them and we'll see.
It seems a bit chicken-egg to me: Are the stocks volatile because there are lots of day traders, or are there lots of day traders because it's volatile.
Ipsam modi perferendis quas maxime. Dicta fugit quaerat et molestias asperiores tempora atque.
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