What is a Forward Volatility Agreement?
Trading is all about risk assessment and a forward volatility agreement is no different. Risk can be used to assess trades and leverage and can even be predicted through a vast array of calculations with various degrees of success.
The definition of a forward volatility agreement according to the SAP Help Portal is that it is an agreement where something can be bought or sold at some point in the future.
It is important to note however, that all forward agreements are binding agreements. This can include a straddle option which is a combination of both a call and a put. When the option expires, the strike price will be set at the forward at-the-money value.
But what is this?
What is a Forward Volatility Agreement?: Forward At-The-Money Value
The term At-The-Money in options refers to the instance when the strike price is equal to the market value of that option. In other words, because the strike price and the market price do not differ, there is no intrinsic value in the stock and no profit or loss will occur. Usually, this means that volatility will increase.
In other words, the forward volatility agreement is based heavily on the implied volatility of an option, stock, etc.
Calculating and trading volatility is very important to both retail and hedge fund traders as it allows them not only to maximize their profits, but also hedge against more volatile trades.
What is a Forward Volatility Agreement?: Implied Volatility
It is important that a person takes note of the difference between implied and historical volatility.
Firstly, historical volatility occurred in the past and is measurable for the most part. It can be calculated over various periods in order to make predictions on the implied volatility, which has not yet occurred, but is instead estimated over a certain period in the future.
The forward volatility agreement usually works using the implied volatility, or predictions of future volatility. It is important to note that these are never guaranteed, and that there is often room for error.
What is a Forward Volatility Agreement?: How does it work?
The forward volatility agreement can be seen as analogous with a forward rate agreement. It is most commonly used by banks in an effort to hedge themselves against the volatile exchange rates of most currencies, so we will be looking at that as an example.
Firstly, both parties who are participating in the currency exchange would have to agree upon a volatility, or measure of future risk. This is usually done using the Black-Scholes equation.
Once the value has been determined, the strike price is assigned on the same day that the agreement is entered.
In other words, the banks lock in on an exchange rate for a set amount of time and can trade regardless of what the market conditions are actually like. This can be both beneficial to the bank and detrimental, due to the fact that the currency exchange rates might rise or fall and that they would be bound to the contract either way.
When used with options, particularly in an options straddle, the risk of potential loss is mitigated as both a call and a put option is defined at the same strike price with the same expiration date.
What are the Pros of a Forward Volatility Agreement?
The forward volatility agreement, and many other mechanisms of trading volatility can allow a person to mitigate risk associated with volatility, and trade regardless of it for a set amount of time at a certain strike price.
This would allow a person to maximize profits if it is used wisely, and future volatility causes a change in price that causes the agreement to be more profitable.
It allows a person to hedge against other trades, especially in a straddle scenario, and allows them to mitigate the volatility of an entire portfolio. This can be especially important for large volume traders, such as hedge fund traders, banks and more.
What are the Cons of a Forward Volatility Agreement?
Firstly, although the price and volatility that has been agreed upon may be beneficial to the person in general, general market conditions might be even better, in which case a person might lose out on potential profits, or even take a loss.
The agreement that is entered into between two parties is binding, and because of that there is a potential risk as future volatility is not always perfectly predictable.
Secondly, it is important to remember when entering into this agreement, that it will always be beneficial to one party and detrimental to another.
For example, if a bank were to agree to a set interest rate with a client for a thirty-day period and the general interest rate of the market was higher when the client took their loan at the expiration date, then the bank would lose money while the client benefited.
Likewise, the client would be charged more interest than they would have otherwise been if they were to get the loan at the expiration date but the market interest was lower, however in this scenario the bank would benefit greatly.
Should you be Trading Using a Forward Volatility Agreement?
The forward volatility agreement provides a lot of potential opportunities for hedging against volatility and risk, as well as maximizing profits in some cases.
However, because of the fact that the agreement, like many other futures, are binding, it is very important that it is approached with extreme caution as, like all other aspects of trading, there is always an opportunity to lose as well, and there is some risk that is involved.
It is also important to note that the entire concept of the forward volatility agreement is based on the implied volatility, and that this is always an estimation and never certain.
For those who are accustomed to mitigating risk, and who are willing to accept the possibility of a loss, this might be a good way to manage your portfolio, otherwise, it might be better to mitigate risk using more conventional methods, such as index funds and bonds.
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