Making the most of a low-volatility environment

Delphine Limpalaer

On February 5, 2018, the world turned upside down. After years of low volatility and chiefly risk-on trading in the equity derivatives market, a sudden, sharp sell-off in stock markets appeared to have given violent birth to a new era. Four months on, that day still casts a long shadow over the market.

Certainly the February sell-off was spectacular enough. The Dow Jones Industrial Average lost 1175 points on the day, and at one stage was down 1500 points, while the Chicago Board Options Exchange (CBOE) Volatility Index, the VIX, surged by more than 100% to 35.2 – the highest point seen since August 2015.

Business as usual?

At the time, big buy-side firms hoped these developments heralded a new climate of higher volatility and correlation, with consequent improvement in the trading environment for professional accounts. The sell-side also saw the move as an opportunity to pitch new deals and structures to clients.

Meanwhile, those exposed to equities became suddenly and painfully aware of the possibility of heavy losses and looked for insurance. “In the height of the volatility in February, you saw demand for hedges and more concern about downside protection from directional investors, while some volatility traders will take advantage of elevated levels and put on the contrarian trade,” says Pam Finelli, global head, synthetic equity and derivatives strategy, equity research, at Deutsche Bank in New York.

However, despite the unexpectedness and ferocity of the move, implied volatility had within a week or two almost come back to the levels seen through much of 2017. Indeed, any further shocks to the equanimity of the market – such as the Italian election and consequently yet another existential crisis in the EU in late May – produced only short-lived spikes in volatility. On June 1, the VIX closed at 13.46. The new world didn’t last long

“There was a lot of pain in the market in February. It was thought that volatility might rebalance at new higher levels, but it didn’t, particularly in Europe. We reverted to the old prices very quickly, and it is difficult to see how we get higher from here,” says Andrew Kent, head of equity index volatility flow trading, Europe, at Société Générale Corporate & Investment Banking (SG CIB).

Running from risk

To add to market difficulties, many clients are now more defensive and risk averse than they were before February 5. The volatility carry trade had, by the end of May, recovered half its previous worth but investors looking to put on new volatility carry trades are likely to want to be more diversified and less aggressive than they were before that fateful day.

One of the reasons why volatility has recovered so quickly is that the sell-off was largely technical rather than fundamental. The initial sell-off in equities was elicited by an unexpectedly high point in the average hourly earnings report in the US and 10-year treasury yield breaking 3% – a key tipping point for equities.

But it was the carnage in the exchange-traded funds market that did the real damage. There were about 20 so-called inverse, or short, volatility funds that paid out as long as the VIX did not increase beyond a designated threshold. Some were levered by two or three times. Once the VIX did hit the threshold, they were automatically redeemed.

The most notorious of these funds was the VelocityShares Daily Inverse VIX Short-Term ETN, more commonly known as the XIV, which was sold by Credit Suisse, and lost 96% of its value from the 52-week highs before it was shut down. The XIV was reported to have had a market value of $3bn before it was wiped out and the other short volatility funds were also wiped out. Retail investors were the worst affected, say sources.

This created an urgent need for issuers to hedge these positions, driving volatility even higher. “Volatility begets volatility. That was why there was such a massive spike. But part of the reason why volatility has now come in so much is that the spike was quite technical. Once the technical issues played out, that overhang was removed and positioning became much cleaner and based on fundamentals,” explains Ms Finelli.

The volatility drag

But long-end volatility has also been dragged lower by the consistent demand for an issuance of auto-callable structured products. In May 2018, issuance levels are said to have been higher than at any stage in the previous three years. The effect of this issuance has been more pronounced in the Asian markets and even in Europe, where comparatively few players trade long-dated volatility so the effect of auto-callable hedging becomes magnified.

Equity auto-callables reference either single stocks or indices, or pairs of stocks and indices. Issuers of auto-callables are long volatility, which means they have to sell volatility to hedge. As the maturity cannot be predicted with any real accuracy, the hedge needs to be highly dynamic and can put pressure on both the term structure and the skew, particularly when there are heavy issuance flows.

This continual and largely unremitting demand to sell volatility drags down implied levels in the longer maturities. Moreover, there is little else going on in these maturities to pull volatility in the other direction. Over the past couple of years there have been a series of macro-economic events that have affected volatility prices, such as the Spanish elections and the Catalan independence referendum in 2017, but this year only Italian turmoil has provided any focus for directional plays.

“Long-term vol is driven by auto-callable issuance. Long-term clients are interested in two things – structured products and directional plays. But this year there has been a lack of specific events to drive directional plays so structured products have been the main drivers,” says Delphine Limpalaer, head of UK equity derivative flow sales at SG CIB.

A quick adjustment

With retail buyers cash rich, there is no sign of any slackening in the demand for auto-callable notes. Meanwhile, the market has shown a somewhat surprising capacity to shrug off any news that might have potential to push volatility higher. This year has been relatively placid in terms of headline news items, but trade war tensions, the possibility of higher rates and a stronger dollar, plus the Italian elections, might, in another year, have pressured implied volatility higher and driven increased equity derivative positioning from professional accounts. Not so in 2018.

“Are we back to a pre-February 5 situation? You’d have to say yes. There was a big spike in volatility on [May 29] due to Italy, but that completely reversed over the next three days. We’re back to the same scenario where we see people putting on carry trades,” says Mr Kent. 

It seems that the market adjusts to any potentially disruptive news very quickly. It also appears untroubled in the face of further developments of a similar nature. What can dealers do in the face of a lack of direction allied to a new skittishness from investors? 

Risk diversification

“The challenge is to address the low levels of market volatility, yet also the potential for sudden spikes which could wipe out carry gains for investors. We’re trying to design smart risk diversification techniques that allow investors benefit from sudden spikes in volatility,” says Arnaud Jobert, head of equities investable index structuring at JPMorgan in London.

He goes on to describe an intraday momentum trade on the VIX that JPMorgan is currently marketing. It is a pretty straightforward product that allows buyers to go long on the VIX at any time during the trading day. If the VIX triggers an upper barrier to the upside, a long exposure is automatically triggered and is closed overnight.

This trade capitalises on the tendency for volatility to feed on itself, gathering strength and velocity during the course of a trading day like a firestorm. Institutional clients like to be long on the VIX as insurance against a sell-off, which leaves dealers short gamma on the VIX and needing to buy even more. When it goes up, dealers have to buy more, and when it goes down they have to sell more.

Dispersion comeback

Dispersion trading, big throughout 2017, has bounced back into favour as well. It combines the same attributes of moderate income plus defensiveness. Dispersion trading is based upon the observed fact that the difference between implied and realised volatility is greater in index options than options on individual stocks, so clients look to sell index options and buy single stock options. It has been popular in both the Eurostoxx and S&P 500.

Once again, this trade generates an attractive, if moderate, return, while providing a bulwark against a sudden sell-off and rise in volatility. “Dispersion gives you a pretty nice carry trade, especially when you have a large sector rotation and dispersion among single stocks, but you also benefit from nice long-volatility profile in times of stress so it’s defensive as well. This is why it has been so popular for the volatility carry investor base. It provides a complement to the volatility carry trade,” says Mr Jobert.

The attractions of the position were exemplified by the events of February 5. While the volatility carry trade was decimated and took a long time to recover, the mark to market on a typical dispersion trade recovered quickly.

However, the sums on plain vanilla dispersion trades increasingly do not add up. The carry is uncompelling and the entry points to the trades – the option purchases – have been expensive. Consequently, there is increased customisation, in which clients look to create bespoke baskets that optimise both the carry profile and the entry points.

“There has been a lot of innovation this year around the theme of dispersion and correlation, on both single stocks and indices,” says Ms Limpalaer. “On the exotic side, the trades with a short [S&P 500] leg are no longer in vogue as everybody is wondering about a long-term change of regime post-February. However, we have seen a lot of interest on index covariance trades, taking advantage of axes from exotic book and correlation moves, post-February spike.”

Banking volatility

In terms of relative value trades across global markets, there has been something of a reversal of sentiment and practice since February 5. Before the sell-off it was more common for clients to sell volatility on the S&P 500 to finance long positions on Eurostoxx or Asian volatility. But since that date, it seems that in the event of another sell-off, realised volatility on the S&P could go higher than European or Asian volatility, as Ms Limpalaer indicates, so there is greater likelihood that the buy-side will sell puts on the Eurostoxx to finance long positions on the S&P 500. Whether political turmoil in Spain and Italy will reset this pattern once more remains to be seen.

Ankit Gheedia, chief equity strategist for BNP Paribas, saw value in banking volatility, or at least he did in mid-May. “There’s a good buying opportunity here. It’s the lowest we’ve seen for 10 or 12 years, in low single digits. This is the lowest we’ve since the [financial] crisis. Yet the cost of equity remains elevated,” he says.

But other dealers say this trade was dead and buried by the beginning of June. “Banking volatility was very cheap, but we’ve seen huge moves in the ‘seven year’ this week [the week ending June 1]. The SX7E [the seven-year banking index component of the Eurostoxx] has gone up by 7%,” says one trader. The index closed at 110.2 on May 31, but was bid up to 112.98 by the close of June 1.

Mr Gheedia has also spotted what he considers an attractive buying opportunity in German equity volatility. He considers that volatility in the DAX has not re-priced in the face of elevated trade war threats, a stronger dollar and euro, and consequent emerging market stress. “The DAX is more vulnerable to emerging market revenues and has a larger proportion of luxury goods in it. Its volatility is currently about 1% to 2% higher than the Eurostoxx, and should be 3% to 5% higher,” he says.

Japanification worries

A term heard frequently in equity derivatives circles these days is ‘Japanification’ – by which is meant a long-term, persistent condition of low volatility, high levels of vega and high levels of convexity. Without strong directions or themes, it is difficult to provide much in the way of exciting opportunities to professional accounts.

Yet the equity derivatives market is not going away; far from it. Though several banks have exited sales and trading in various products over the past four or five years, there are still enough banks committed to the product to generate liquidity across a wide range of products. The French banks lead the pack, as ever, and SG CIB says it has had a strong start to the year in both flow and exotic products.

JPMorgan is a strong presence, and Goldman Sachs is said to be both strong at the short end of the curve and is also building an exotics book. The Swiss banks quote prices in a healthy mix of products as well.

There will always be clients who need to hedge plentiful equity exposure to the upside and downside. The market is big enough and deep enough to generate professional position taking. “I don’t see the dark clouds other people see. But if you come back to me in six months’ time and there is still very low realised volatility and very low implied volatility, it might be a different story,” says Mr Kent.