Buyside Strategies EQD Research Volatility
Jun 15, 2020
By Russell Rhoads, head of research
When volatility expectations increase in response to a macro news item the upside move is often very quick. Many of these quick upside moves for a volatility index are the result of unanticipated weakness in the associated equity index. However, there are times that the reaction comes on the heels of a ‘known unknown’. This type of event may be a major economic number or something politically oriented such as the outcome of an election or new legislative proposal.
As an example of being prepped for a potential reaction to pending news we took a look at price action in early October 2019 that coincided with one of the many Brexit-related news items that impacted European stocks. News was expected to come out on Oct. 2 with respect to several aspects of the Brexit process. Pricing for the three general strategies shared below is based on the Oct. 1 closing prices and the anticipated pricing for the following day is based on a Black-Scholes calculation that assumes one-day theta and the individual option implied volatility remaining stable. Various front-month October VSTOXX options with 11 trading days remaining to expiration were priced out. Finally, the closing price for the VSTOXX October future was 16.85.
This is a pretty basic trade, but for a single-day holding period just buying a call option is not a bad approach. The leverage to the upside is unlimited, but the option will experience a bit of time decay which is always an issue with a pure long option position. Due to the normally elevated implied volatility associated with VSTOXX options (all the contracts in this article have an implied volatility between 80% and 120%) time decay should be more of a consideration.
For a couple of choices, we looked at the slightly in-the-money October 16-strike call which was trading at 1.60 points and the just out-of-the-money 17 call which could be purchased for 1.30 points. The following table summarizes estimated outcomes for purchasing either call for a one-day trade.
The choice between either the 16 or 17 call is based on what sort of conviction a trader has with respect to the following day’s price action. If there is a high level of conviction that the October VSTOXX future will experience a dramatic move to the upside then the 16 call offers a better outcome. If the trader is less certain about a potential upside move the 17 call might be a better choice since the loss incurred based on the VSTOXX future moving lower is less than the loss associated with purchasing the 16-strike call option. The payoff diagram below illustrates the outcomes of a one-day trade purchasing both options.
The break-even for both trades is slightly higher than where the future was trading when these options would be purchased for a one-day hold. This is common whenever any option is purchased due to time decay. The leverage that makes the 16 call a better alternative if the VSTOXX future rises dramatically the following day shows up on this diagram.
Bull Call Spread
When options are expensive, which can be a function of high implied volatility, traders often look to sell an option to offset some of the cost of a trade. Buying both the 16 and 17 calls were combined with selling out-of-the-money calls to create bull call spreads. First buying the 16 call and selling the 20 call would result in a cost of 0.95 points while purchasing the 17 call and selling the 21 call would result in a cost of 0.75 points. The table below highlights the expected one-day price change for each spread.
The spread using the lower strike prices offers more upside than the 17/21 bull call spread, but does not hold value as much as the 17/21 bull call spread in the case of a drop in the corresponding future price. Both spreads offer lower returns than just owning a call, but the lower cost of a bull call spread makes them popular, even for short-term trades among volatility traders. Also, if VSTOXX is unchanged on the day (unlikely, but worth discussing), both spreads basically break-even. This aspect of the short-term bull call spread shows up in the payoff diagram comparing the two trades below.
It is difficult to see on the payoff diagram, but the break-even for the 16/20 call spread is about 16.80, just a bit lower than where VSTOXX closed on the day before the potential move up in volatility. The 17/21 call spread break-even is a little higher, at 16.85. As noted, once the price drops a little more the 17/21 call spread holds its value better than the 16/20 call spread.
Short Put Plus Bull Call Spread
Finally, a pretty popular trade in the volatility space combines selling an out-of-the-money put and combining it with a bull call spread. This approach is popular when using VSTOXX options to hedge an equity portfolio because the risk associated with the short put may be offset by an increase in equity prices. These spreads also pop up in front of scenarios such as Brexit announcements. If the 15 put were sold and combined with purchasing the 16 call and selling the 20 call the net result would be a spread trade costing 0.55. Another spread would combine selling the 16 put with buying the 17 call and selling the 21 call for a net credit of 0.05 points. Of all the strategies discussed here, this spread is the only one of the six strategies that takes in a credit when initiated. That is something that many traders find attractive, even if it does not impact the ultimate outcome of the trade.
The payoff table below compares the two spreads. In the previous two examples the trade with the 17 call was the better of the two for any upside move. In this case the outcome is mixed depending on the extend of the move to the upside. A true volatility spike, pushing the October VSTOXX future over 19.00 favors the spread that is short the 16 put and buys the 17/21 call spread. Smaller VSTOXX gains result in a slightly better outcome when the 15 put is sold short and the 16/20 call spread is purchased.
In addition, the short 15 put combined with 16/20 bull call spread results in a small loss versus the outcome for the other spread if there is a drop in the VSTOXX future price. One other aspect to this trade, and a reason that traders find this approach attractive in front of a ‘known unknown,’ is the break-even level for both trades which is a bit lower than where the underlying market was trading when the spread was initiated. This shows up on the final payoff diagram shown below.
The break even for the short 15 put, long 16/20 call spread is 16.75, while the break-even for the short 16 put combined with buying the 17/21 call spread is at 16.80. In the first two examples there were pros and cons to which options to use based on an outlook. In this final multi-leg spread example, it is really hard to make an argument for shorting the 15 put and buying the 16/20 call spread versus selling the 16 put and buying the 17/21 call spread when a trader believes VSTOXX will move dramatically higher over the next day.
Quick moves up in VSTOXX are often the result of a surprise move to the upside that coincides with a drop in the EuroStoxx 50. I discussed a method to prepare for such a situation recently in an article that may be found here: Ready And Waiting For The Next VSTOXX Rally. Known unknowns such as a major economic number, election outcome, or other major macro-economic event offer a chance to either speculate on an upside move or use VSTOXX options to guard against a short-term downside move in stock prices as represented by the EuroStoxx 50. Three general approaches have been laid out in this space, of course there are plenty more alternatives using VSTOXX options and futures to guard against such a market move.