Ash Alankar, Global Head of Asset Allocation and Risk Management at Janus Henderson, does not expect a sustained selloff in equities according to signals from the options market. This article first appeared on Bloomberg View on 2 March 2018. Republished here with permission.
The wild gyrations in capital markets in early February had a profound impact on investor sentiment. The spike in implied volatility, as measured by the CBOE Volatility Index, or VIX, roiled long-Pacific markets, leading investors to question, even almost a month later, whether a sustained selloff might be looming. According to signals from the options market, the answer is no.
Options prices, which contain valuable near-term information about the market’s assessment of upside potential and downside risk, are showing average levels of risk for US equities. As reflected in chart 1, options prices suggest more normal conditions ahead, rather than indicating rising risk of a substantial drawdown. That can be seen in the implied volatility of out-of-the-money put options on the S&P 500 Index, which reflect the price investors are willing to pay to protect against large losses. At a recent level of 16.1, implied volatility was near the median of 16.57 over the past 10 years.
Chart 1: options prices indicate average levels of risk for US equities
Source: Bloomberg, as at 28 February 2018.
A consensus trade over the past several months has been to bet on low volatility, otherwise known as ‘shorting’ volatility, on the expectation that near record-low market volatility - for both stocks and bonds - would continue unabated. This was a logical and rational response to ultra-accommodative monetary policies that drove real interest rates to abnormally low levels, likely leading pension funds, endowments and other institutional investors to find alternative ways to boost returns, such as by selling options and volatility.
These short volatility, or ‘short vol’, trades are mostly concentrated among institutional investors, with banks taking the other side of the trade. That is a crucial structural difference between today and 2008: a key trigger for the credit crunch was banks holding short vol positions through Special Investment Vehicles (SIVs) and other instruments in the shadow banking system.
US wage growth data for February was higher than expected; sparking concern that faster-than-anticipated inflation would lead to faster-than-anticipated rate increases, particularly real rates. This concern led to the selloff in equities, likely exacerbated by forced selling by commodity trading advisers and by delta hedging among those shorting options and volatility targeted strategies. Volatility spiked higher than during the Lehman Brothers crisis as investors rushed to cover their short vol positions, perhaps one of the most crowded trades ever.
Although there was initial fear last month that significant losses incurred by holders of short vol positions could lead to a greater selloff, contagion was contained because banks were generally the counterparties to such trades, as opposed to bearing the exposure. This should remain the case so long as short vol positions are in the hands of institutional investors and not banks. While a crippled banking system can bring an economy to a standstill as the flow of money stops, a stable economy is more able to cope with the hit incurred by institutional investors who understand the risk and have the resources to absorb the losses from such trades.
It should not be forgotten that February’s selloff was catalysed by a fundamental structural risk: a faster-than-expected rise in real rates. This kind of event could push markets into a sustained correction and challenge real economic activity. So the movement of real rates offers clues about the potential severity and permanence of a market drawdown. Even with recent upward moves, a US 10-year real yield at 75 basis points is artificially low and is a direct result of years of stimulative monetary policy. But if real rates continue to surge, the real economy may not be able to absorb a rapid increase in the real cost of capital, raising the possibility of a more significant drawdown.
Real rates are a key indicator of potential turbulence and could signal dangerous downdrafts if they rise too quickly. Furthermore, if banks begin to pile onto the short volatility train, a derailment could also upend the economy. The good news for now is that the options market does not see an epidemic unfolding and, while the downside risk to US equities has increased, it has simply gone from abnormally low to more normal levels, which is all part of the normalisation that is now underway.
Put option: gives the buyer the right, but not the obligation, to sell a specific quantity of a particular security by a specific date. The holder hopes the underlying asset, such as a stock, will drop in price.
Delta hedging: an options strategy that aims to reduce (hedge) the risk associated with price movements in the underlying asset by offsetting long and short positions.
First published on Bloomberg View on 2 March 2018. Used with permission.
The opinions expressed are those of the authors and do not necessarily reflect the views of others at Janus Henderson Investors. Nothing in this article should be construed as investment advice.