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EQD Research: Market Fragility And Other Themes For The Second Half of 2021

Jul 7, 2021

By Russell Rhoads,
head of research

We could be witnessing a regime change in asset correlations and market volatility, according to a recent Optiver webinar that brought together hundreds of international financial players, Optiver senior traders from the US, Europe, and Asia were joined by hedge fund portfolio managers who covered major themes -including market fragility, inflation and elevated near-term volatility.

Firstly, the market remains fragile. Institutions protecting portfolios in the options market highlight this fragility. The hedging activity, plus other trends in the volatility space, contributes to elevated skews. Skews remain elevated even after the most recent Fed meeting, a situation that is surprising to many market participants. One indicator of SPX skew is the Cboe SKEW Index (SKEW), which hit an all-time high a few days after the Optiver call, confirming market participants are still paying up for portfolio protection. The chart below is a good visual representation of just how high skew is in the SPX option market.

Data Source: Cboe Global Markets

This chart shows the monthly range for SKEW from January 2010 to June 2021. The average close in June for the index was the highest average on record compared to data going back to 1990. Average close combined with other measures of option skew all indicate SPX puts are expensive relative to historical levels.

Hedging equity portfolios through the combination of selling a call and buying a put spread is a popular strategy when out of the money put implied volatility is elevated. A prime example of this trade hit the tape the morning of June 30 using SPX options expiring on September 30. With the S&P 500 at 4295, there was a large seller of the SPX Sep 30 4420 calls at 51.21 who purchased the Sep 30 4060 puts for 68.89 and finished the spread by selling the Sep 30 3425 puts for 16.17, resulting in a cost of 1.51 per spread.  The payoff of this spread, when combined with a long S&P 500 position, appears below.

This particular hedge trade guards against losses of over 5.4% in the third quarter down to losses of 20.3%. The dollar cost of this spread is miniscule relative to the notional size of the S&P 500 –the real cost is that gains are capped at up 2.9% during the quarter through the short call. One of the Optiver panelists stated they continued to see this sort of trade in the market place, as the focus for hedges is moving to September and a quick look at the tape confirms this trend. Another panelist was very bearish on equities, an outlook that matches up with the trade above.

Inflation also emerged as an important theme. This is certainly on everyone’s minds as the year progresses and traders are monitoring Fed action in response to any inflationary concerns. Traders are keeping an eye on CPI and other inflation indicators as well as looking forward to any statements that may come out of Jackson Hole in late August. Not all panelists believe in the inflation story, with a strong case made for recent inflationary pressures being transitory.  “Everyone is talking about CPI and inflation prints”, noted one Optiver panelist, “but in my view, supply chain constraints are not permanent. What are permanent are structural deflationary forces. Technology, working from home, globalization, ageing demographics – all these are deflationary. I’d say the downside risk to equities is a lack of inflation, not inflation itself”.  Another panelist chimed in stating that trades expecting inflation are already in place and that their mother had recently asked about inflation, a good indication that everyone is aware of the inflation story.

Finally, near term volatility remains relatively elevated, even with the S&P 500 making all-time highs. Systematic volatility sellers have not completely returned to the markets after the events of early 2020. Volume and open interest numbers back this statement up, but this is surprising since the performance of short volatility strategies quickly rebounded. The following chart uses data from the Eurekahedge Short Volatility Index, adjusting it to 100 as of the last day of 2019.

Data Source: Eurekahedge

The performance rebound from early 2020 was very quick and the Short Volatility Hedge Fund Index finished down less than 1% for the year.  Over the first five months of 2021, short volatility strategies are up just over 6%. Capital should return to short volatility strategies as VIX trends lower and short volatility funds continue to put up solid performance numbers.  A poll among participants at the webinar showed 39% foresaw the VIX averaging 21-25 in the second half of 2021, with 37% expecting an average in the 16-20 range. However, comments later in Optiver’s webinar supported a bear market in volatility over the next few months, so investors may want to consider adding short volatility sooner rather than later.

Finally, the VIX curve remains steep (see below) which is providing opportunities for those that agree a lower VIX is on the horizon.

Data Source: Cboe Global Markets

The recent Global Volatility Discussion hosted by Optiver highlighted that market participants continue to be on edge, with resulting hedging activity focusing farther out into 2021. Strategies such as the put spread plus short call remain popular, as out of the money put options are relatively expensive, so traders are taking in premium and sacrificing upside to pay for protection. The market is already pricing in inflation concerns and recently it appears that these concerns have dissipated, but not fully disappeared. Finally, VIX remains relatively elevated, especially considering the S&P 500 continues to grind higher. The VIX term structure is steep, so opportunities to take advantage of a bearish outlook for VIX are attractive.