(Bloomberg) -- The world is short volatility. How long it can remain so is another matter.
Whether for a long-equity fund, value investor or what's seen as a diversified portfolio, the net exposure is essentially short volatility. Safety in spreading out investments only works if correlations between assets don't converge in times of market turmoil. Increased gyrations in the global equity bull market are already signaling an impending change of climate and, as a trade war between the U.S. and China escalates, that means cost-efficient long-volatility exposure may be a new focus for investors.
The blowup in short-VIX exchange-traded products in February was a stark lesson in the reality of asymmetric payoffs -- during a sharp slide in equities, volatility moves can far exceed changes in the underlying asset. Convexity options outperform in aggressive selloffs given volatility gains accelerate as equity declines, even though this disproportionate reward versus risk has a carry expense. Still, buyers of convexity exposure may cut costs by using the relative value between VIX calls funded by SPX puts.
If It's the Big One for Stocks, Hedgers Are Looking Unprepared
Increased leverage in the financial system may amplify volatility in a big selloff. Margin debt, compiled by FINRA, is the money clients borrow from brokerages to purchase securities and remains near record highs. While not predictive of a market slump, it is just one reported indicator that highlights elevated risk in the system. While the demand for short-VIX ETPs into the February blowup was transparent given these products are exchange-traded, mountains of leverage likely remain hidden elsewhere in the system.
- A balanced approach toward volatility consists of constructing net long exposure overlaid with a tactical short to mitigate cost via relative value. Global trade-war fears have pushed short-dated SPX volatility to historically elevated levels versus long-dated, which may fade on the view that tensions will subside ahead of mid-term U.S. elections as President Donald Trump will likely want to maintain economic confidence
- VIX calls funded by SPX puts create cost-efficient long convexity exposure given VIX call options tend to outperform SPX puts during sharp selloffs; however, basis risk needs to be managed where, for example, the market exhibits a slow decline with limited volatility
- Given that a highly-leveraged economy is more sensitive to short-term rates and has effectively borrowed from future growth, along with the inability of central bank intervention to deliver more inflation and growth, extremely elevated levels of volatility may be unsustainable in a world of persistently low real rates
- Markets are at risk of becoming more fragile with major central banks' balance sheets peaking, a deeper OTM Fed put strike and the restrictive effect of higher yields, exposing the debt trap
- Exposure to both tails of the return distribution may increase with inflation volatility remaining the key bearish risk while any resurgence of productivity may extend this bull market
- Goldilocks backdrop of strong growth, low recession risk and low rates and limited inflation pressures has prevented convexity performance; however, as confidence fades that these favorable dynamics will last, it is unlikely realized volatility will settle back to single-digits -- given volatility is a function of the business cycle
- NOTE: Tanvir Sandhu is an interest-rate and derivatives strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice.
To contact the reporter on this story: Tanvir Sandhu in London at tsandhu17@bloomberg.net.
To contact the editors responsible for this story: Ven Ram at vram1@bloomberg.net, Anil Varma, Neil Chatterjee
©2018 Bloomberg L.P.
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