The Barclays Trading Strategy that Outperforms the Market

Demystifying the Barclays U.S. Equity Derivatives Strategy — Capitalizing on Retail Options Trading

In 2022, Barclays released a comprehensive 30-page report outlining an innovative options trading strategy that capitalizes on the volatility mispricing of single stock call options.

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This strategy has demonstrated the potential to outperform the market by exploiting the gap between implied volatility (IV) and historical volatility (HV).

Explore what this 30-page report reveals and what it means for retail traders with the link below:

The Volatility Conundrum

To understand Barclays’ strategy, we must first grasp the concept of volatility. In the options market, prices are influenced by the expected future volatility of an underlying asset. Higher expected volatility translates to more expensive options.

Understanding IV and HV Implied volatility (IV) is a forward-looking measure of the market’s anticipation of a stock’s future price fluctuations. It is reflected in the premium of options contracts. Historical volatility (HV), on the other hand, represents the actual past volatility of a stock’s price movements.

Barclays noticed two intriguing trends related to this volatility:

1. Volatility Risk Premium Decrease: Some stocks saw a reduction in the gap between expected (implied) volatility and actual (realized) volatility. In simpler terms, the market often overestimated future volatility, but that gap was narrowing for select stocks.
2. Increased Hedging Share Volume: Market makers who sold options found themselves buying shares of the underlying stock to hedge their positions. This hedging led to higher trading volumes, which further impacted stock prices.

In Short: Taking Advantage of The Volatility Risk Premium When IV exceeds HV, it creates a volatility risk premium, an opportunity to make profitable trades. This premium arises from market makers’ hedging activities to protect their portfolios from potential price swings.

The Barclays Strategies: Making Money from Retail Traders

The backdrop of this story is the surge in retail options trading. With platforms like Robinhood offering commission-free options trading, a new generation of traders emerged. Armed with stimulus checks and a desire for risk, they have dived headfirst into the world of trading. This wave of new traders brought an abundance of fresh capital and enthusiasm to the market. The surge in retail trader participation in short-term, out-of-the-money call options has significantly impacted on the dynamics of options pricing. Retail traders often buy these options with the hope of quick profits, pushing up premiums and IV.

The Market Maker Response To maintain their hedged positions, market makers respond to the increased demand for call options by buying more stocks. This stock buying further drives up the stock price, fueling a cycle of rising IV and stock prices.

Barclays’ Approach: Selling Straddles and Shorting Volatility Barclays’ strategy leverages this volatility mispricing by selling straddles or shorting the volatility of stocks with elevated IV relative to HV. Straddles involve selling both a call option and a put option at the same strike price, while shorting volatility involves selling options contracts to profit from a decline in implied volatility.

Identifying Stocks with Mispriced Volatility To identify stocks with mispriced volatility, Barclays employs a proprietary metric called VolScore. While the exact methodology of VolScore remains undisclosed, one alternative approach involves identifying stocks with wide spreads between their IV, sector-wide realized volatility, and their own realized volatility. This approach is based on the assumption that a stock’s volatility will eventually converge with the sector’s average volatility over time.

Barclays’ report outlines two key strategies that capitalize on these trends:

1. Monetizing Elevated Volatility with Short Delta Hedge Straddles The term might sound complex, but the strategy is straightforward. Barclays suggests selling or shorting volatility on specific stocks. To put it in simpler terms, they bet that the market’s anticipated future volatility is too high.

Imagine you can place a bet on a stock without caring about its direction — whether it goes up or down. You’re just betting that it will make a significant move. This is what selling a straddle does. It’s like saying,

“I bet this stock will be much more volatile than everyone thinks.”

If that prediction comes true, you make money. It doesn’t matter whether the stock rises or falls — what matters is the extent of the move.

2. Buying Long Call Spreads on Stocks with Converging Implied and Realized Volatility This strategy involves buying a long call option (a bullish bet) and simultaneously selling a deeper out-of-the-money call option (a bearish bet) on a stock where implied and realized volatility are coming closer together. In simpler terms, you’re making a directional bet on a stock while also capitalizing on the fact that the options market might have overpriced volatility.

In this strategy, your directional exposure is more prominent than your volatility exposure, making it a less risky play.

The Impact on Retail Traders

So, how do these strategies impact the retail traders who have flocked to platforms like Robinhood?

1. Lower Volatility Premium: By selling straddles on stocks with overpriced volatility, institutional investors like Barclays are essentially taking money from retail traders who overpay for options.
2. Greater Trading Volume: The increased share volume generated by hedging strategies employed by market makers can further influence stock prices. This means that the actions of retail traders, buying options and influencing market makers’ hedging, can impact stock prices in unforeseen ways.
3. Retail Trader Consideration: Barclays’ report notes that stocks with the highest retail option volume outperformed the index. However, this might also be due to the resilience of these stocks during the pandemic. The report doesn’t definitively prove causation but highlights the correlation.

The Takeaway: Insight and Caution

While Barclays’ strategies may appear complex at first glance, they fundamentally revolve around the relationship between implied and realized volatility. The report provides valuable insight into how institutional investors adapt to market dynamics.

Barclays’ options trading strategy offers a unique approach to profiting from volatility mispricing. By understanding the interplay between IV and HV and the role of retail traders and market makers, investors can potentially exploit these dynamics to generate returns that exceed market benchmarks.

However, for retail traders, it’s essential to understand that while these strategies might seem appealing, they come with their own set of risks like: timing, execution, and risk management are crucial when considering any options strategy.