A few weeks ago, we had strong data coming from the US, indicating an increase in probability (which is now at 70%, calculated from interest rate futures on FED Funds Rates) that the FED will hike interest rates in the next December’s meeting. Non-Farm Payrolls, which are released the first Friday of every month, were better than expected (271k vs. 180k) and the unemployment rate fell to 5%, near the full employment rate of the Federal Reserve that is 4.9%. On the other side of the ocean, ECB President Mario Draghi stated the willingness of the committee to add further stimulus to the economy as concerns about inflation still persist. The are three strategies that the ECB could use: cutting the deposit rate of 10 basis points to -0.30, increasing the size of the QE or extending the duration of the program which is now supposed to end in September 2016.
In one way or another, we are entering a unique period where monetary policy divergence will be the main driver for the markets. The effects of further stimulus by Mario Draghi are simple to understand: equities will benefit as the Euro depreciates and, also, because there will be a “risk-on” environment where investors will be more willing to invest in riskier assets instead of bonds. Furthermore, this will also further assess the negative correlation between European equities and bonds. Thanks to such, there is a high probability that the volatility in European equities will increase substantially, due to the fact that investors will be extremely willing to buy low and sell high.
Regarding US equities, the situation is more ambiguous: hiking interest rates is a sign that the US economy is doing well and this is bullish for equities. For instance, higher rates also mean that the rate of interest at which you discount a company’s dividends will increase, thus the share price could take a hit; on the other hand, higher rates will mean a stronger US dollar, which will surely impact multinationals’ earnings in the long run. Hence, the volatility in US equities is likely to decrease as the effect of an interest rate hike will be ambiguous and investors will surely prefer to invest in other assets.
Given the situation, there is a trading strategy that we can adopt when the monetary policy divergence will be effective. We can trade volatility, shorting S&P 500 volatility and going long on European stocks volatility. We are referring to implied volatility, which is the volatility implied by options prices observed in the market. Regarding the S&P 500, we are referring to the SPX VIX, which is an index of the implied volatility of 30-day options on the S&P 500 calculated from a wide range of calls and puts. Regarding European Equities, we can easily refer to the VSTOXX index based on EUROSTOXX 50 or the VDAX-NEW based on the DAX.
So, how can we trade vol?
Roughly speaking, the volatility of a stock price is a measure of how uncertain we are about future stock price movements. As volatility increases, the chance that the stock will do very well or very poorly increases. For the owner of a stock, these two outcomes tend to offset each other. However, this is not so for the owner of a call or put. The owner of a call benefits from price increases but has limited downside risk in the event of price decreases because the most the owner can lose is the price of the options. Similarly, the owner of a put benefits from price decreases, but has limited downside risk in the event of price increases. The values of both calls and puts therefore increase as volatility increases, and vice versa.
As we are trading volatility, we have to introduce a couple of greeks to better assess our risk when dealing with options. Delta, measures the sensitivity of an option to changes in the underlying price, vega is a risk measure of the sensitivity of an option price to changes in volatility. If vega is highly positive or highly negative, the portfolio’s value is very sensitive to small changes in volatility. If it is close to zero, volatility changes have relatively little impact on the value of the portfolio. Thus, coming back to our trading strategy, in order to be successful, we will just buy and sell options to profit from changes in implied volatility. Regarding the S&P 500, we can short index call options with a negative vega and buying them back when the volatility will decrease, as their value will be lower; regarding European equities, we can go long on index call options with a positive Vega and selling them when the volatility will increase, as their value will be higher. It is necessary to mention that we could also have bought or sold directly the implied volatility index, but one contract on the VIX index, for example, is on 1,000 times the index. Thus, trading options our loss is limited.