- Scott Nations is the president and chief investment officer of Nation Indexes, which focuses on creating volatility, option cost, and option strategy indexes.
- Nations partnered with the Nasdaq to create the Nasdaq-100 Volatility index (VOLQ), and its futures started trading on the CME on October 5.
- He shares how investors can hedge their tech-heavy portfolios and use a unique strategy to generate risk-return profiles based on their views on where the Nasdaq and S&P 500 could move.
- Visit Business Insider's homepage for more stories.
After more than 12 years as an options trader on the floor and another dozen years running his own volatility and arbitrage-focused trading firm, Scott Nations knows a thing or two about the art and science of options trading.
Nations began his career in the trading pits as a floor trader at the Chicago Mercantile Exchange. During most of his time there, he ran a successful options trading group focused on fixed income options and index options.
"I like trading options. I started trading options professionally on the floor because there was a problem to be solved and I wanted to solve the problem," he said. "That is, what is this option worth. And I enjoyed trying to solve that problem."
When the era of open outcry ended, Nations and his team moved upstairs and shifted to electronic trading.
"The physical pit was always a tremendous amount of fun and it was very different than trading electronically. It can be a tough transition to make," he said. "We were able to do so because we approached it differently. We created these unique measures to tell us what's really going on in the option world."
Indeed, rather than merely replicating what he did on the floor, Nations started building his own volatility measures in order to understand what different types of options are telling him in this new trading regime. From there, his eponymous firm — Nations Indexes — was born in 2014.
Creating a better measure of implied volatility
When he realized the market lacked a tool to help traders deconstruct skew, Nations partnered with the Nasdaq to create the Nasdaq-100 Volatility index (VOLQ).
Skew refers to the difference between the implied volatility or the uncertainty of an option's underlying asset for out-of-the-money options, at-the-money options, and in-the-money options. It serves to inform investors about whether fund managers prefer to write call options or put options.
"Whenever anybody walked back into a trading pit or later when they sat back down at a trading desk. Generally what people want to know about an option market was — what are the at-the-money options doing," he said, referring to the options with a strike price equal to where the market is right now.
"That's really what people wanted to know to begin with and then they would fill in the rest of the picture themselves," he added. "And nobody was deconstructing skew for traders to really help them understand these issues."
Nations believes that VOLQ is a better measure of implied volatility compared to the CBOE Volatility index (VIX) mainly because of the different ways each index is calculated.
VOLQ, which focuses on at-money-options, is calculated based on the values of 32 Nasdaq-100 index options: the two nearest in-the-money and out-of-the-money puts and calls for the next four weekly expirations, according to the index factsheet.
The VIX is calculated based on a strike price-weighted average of at-the-money and out-of-the-money put and call options with more than 23 days and less than 37 days to a Friday SPX expiration date, according to its methodology sheet.
He used the Nations VolDex (VOLI), which measures the large-cap implied volatility of the next 30 days, as an example.
"If you look at VOLI, it's up 2.5% today and you know exactly what that means. It means the at-the money-options 30 days out are up and that implied volatility is up 2.5%," he said of the index moves on Monday at around 3 pm EST. "Compare that to the VIX, the VIX is up about 1.4% right now, but there's no way to know where that's coming from."
He continued: "Is it coming from at-the-money options, that tells you one thing if that's the case; is it coming from out-of-the-money puts, that would tell you a very different thing… if you don't break it down, then there's no way to understand what the option market is really saying."
Ways to hedge and profit with the VOLQ
Since the CME Group launched futures on the VOLQ on October 5, traders can hedge their stock market risk with the index futures or express their views on the implied volatility of the Nasdaq-100 index.
"If your portfolio looks like the Nasdaq 100, and more and more portfolios are, then you can buy VOLQ futures as a means of hedging your portfolio," he said. "So something like buying futures can be a great resource for those people who want to hedge but don't necessarily want to hedge by selling a portion of their portfolios."
Another way to use the futures is to spread VOLQ futures against VIX futures. This allows traders to get exposure to things like option skew and the difference in volatility between the S&P 500 and Nasdaq-100.
"Because they have a point of view about what the Nasdaq 100 is going to do versus what the S&P 500 is going to do," he said. "Spreading VOLQ against VIX generates absolutely unique beneficial risk-return profiles, and it was impossible to get before October."
The art and science of options trading
In a year where stock options trading exceeded stock trading itself over the summer, Nations says that options can be "a great tool" if retail investors use them sensibly, but less likely so if options are used for wild speculation.
"Options trading volume has really increased recently. And there's been some talk that some traders or investors have really focused on a couple of different names," he said. "For some of these stocks, you have to look at where the volatility is actually coming from or where people are really focused when they're executing options strategies.
"Because if all you do is say a strike price-weighted average of implied volatility goes up again," he added. "It doesn't really give any information."
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