The Green Slopes of ED Vol

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Vol may be low but we still see opportunities in Eurodollar Vol. Below we look at buying mid green straddles vs selling long green straddles which offers around 10.5 annual-bp-vol of vol roll down over 9 months while being long gamma. These are the eurodollar atm straddles at time of writing, looking at September expiries across the fronts/reds and longs and also the 1y, 2y and 3y mid curves:

The z-scores tell us what we all know, vol is at extremely low compared to recent history. Notice that the vol term structure is upward sloping, and yet, mid-curve vol is relatively flat to the non-midcurve with the same underlying future: eg green sep vol is 31.14 where long green sep vol is 30.46. For this to be correct it means come September next year implied vol needs to be a lot higher than it is now.  Here I’ve calculated these implied forward vols and compared them to their current equivalent. The difference between these two numbers gives us the implied vol roll down:

The sweet spot here looks to be 2eu^ vs edu3^ where you get 10.45 annual-bp-vol of roll down over approximately 10 months. In terms of price that equates to 9 ticks:

By plotting the synthetic history of that 9 ticks you can see it’s at a high:

This is all supportive of buying 2eu^ vs selling edu3^. It’s a long gamma, short vega trade that’s also long theta once roll down is taken into account. Here’s the backtest chart for the trade going back 3 years.

On this chart the x-axis represents trade entry date. The y-axis is profit at the time of the first expiry (ie the mid-curve), so it assumes the unexpired leg is closed out at that point. Note that points to the right of the 10th of Feb represent trades that are still running, points to the left have been fully closed out. Over the last 3 years this trade has returned over 20 ticks of profit on average.

An uptick in vol without a big move in rates represents the biggest risk to this trade. If you are worried about vol rising consider hedging the vega with a long red sep straddle position – run delta hedged.

For pricingMonkey users you can follow how this trade performs on a shared blotter here:
https://pricingmonkey.com/b/b52486d5-0126-413f-bb49-920bb33722e8
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