Recent equity market upheavals are presenting new challenges and opportunities for volatility and correlation traders. With the downturn in markets that kicked off at the end of February came a massive jump in short-dated implied volatility. The Chicago Board Option Exchange’s Vix index, which measures the implied volatility of S&P 500 index options and represents the market’s expectations of volatility over the next 30 days, jumped almost 80%, increasing from about 10% to 18%. Volatility in other major equity markets, such as the Eurostoxx, also jumped, as did equity market correlation. The 30-day realized correlation level on the Eurostoxx 50 doubled from just under 20% to 40%. Immediately before the downturn, volatility and correlation had been trading at historically low levels.
This presented investors with the opportunity to buy short-dated volatility at what suddenly looked like very cheap levels. "At the start of the sell-off we saw March implied volatility levels whip up from a very low base, but we didn’t really see much contagion on the longer-dated months," says Pete Clarke, equity derivatives strategist with Citigroup in London. After a few days of market turmoil the bid levels on volatility at the longer end of the curve also started to go up, but not nearly as much as those at the short end. The result was an inversion of the term structure on implied volatilities.
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The jump in correlation |
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Source: Citigroup |
In order to take a long view on correlation, which would make money when correlation increases, traders can simultaneously buy index variance and sell single-stock variance. As the volatility kicked in at the end of February, dealers saw a surge in clients looking to put on correlation positions. "On the very first day of the sell-off, on the 27th, correlation started to look attractive," says Clarke, adding that traders were looking to last May and June’s sell-off to gain a steer on how markets will react this time. "In the first leg of the sell-off in May and June we saw buyers of short-dated volatility at the front month but the back end of the curve didn’t really lift up very much until later on in the dip. We’ve got a similar position now, with longer-dated implieds having actually moved up by less than the skew originally predicted, reflecting the pressure from correlation sellers."
Jitters
Meanwhile, those that have put on covered call writing strategies, which involves selling call options on a stock or a basket of stocks, might also be getting jittery. This strategy performs best when the underlying equity market does not rally through the strike price of the options the investor is selling. Say, for example, the investor is selling 105% one-month call options as part of a covered call strategy. As long as the market does not rally by more than 5% in any given month the investment will outperform a long-only strategy. When the market experiences a bout of massively increased volatility, however, the probability of such strike prices being breached also increases. On the other hand, if the market sells off significantly, the covered call writer has a cushion on the down side through taking in option premiums, which will to an extent offset losses. Also, the increase in volatility has pushed up the price of call options, increasing those premiums.
At the time of writing Eurostoxx short-dated volatility was trading towards 30%, while June volatility was trading a little under 19% – historically high numbers that will feed into relatively expensive option prices. "But the question in terms of their out-performance versus long-only funds is how hard and how fast the index rebounds from here, if it rebounds," says Clarke. "I would be nervous about writing calls at the moment."