Article / 20 December 2016 at 11:30 GMT

Volatility Update: Going into the unknown — #SaxoStrats

Product Manager, Options Trader, Educator
Denmark
  • Investors should favour buying options rather than selling in low volatility
  • Hedging is always an appropriate strategy when the fear factor is low
  • Valuations in the S&P 500 seem to be near all time high - what choices are there?
By Georgio Stoev 

Let's start with a breakdown of the last week's market action by different asset classes...

performance
Source: QuikStrike

US equities have held their gains for six straight weeks now. The S&P 500 is on track to register double-digit returns for the year, following a dismal 2015. 

For the week ending December 16, lean hogs (HEG7) were the best performer, followed by RBOB gasoline (RBF7).

To some of us these products may be a little obscure; I mean, who really thinks of pork unless its in the form of a roast? But the two contracts have been ripping it up in the last month.

Leaving the jokes aside, pork is become popular commodity and gaining numbers due to the increasing demand from markets such as China.

xxx
 All plain sailing? When volatility is weak, consider hedging your positions. Photo: iStock

After Friday's break above $62.35, the contract for February delivery looks to be heading up back to the high from this summer.

Lean hogs monthly chart:

lean hogs

Create your own charts with SaxoTraderGO click here to learn more

Source: Saxo Bank

A bullish idea on gold

While pork meat is trading on the upside, there were plenty of losers. Metals and rates got pounded again.

Gold (GCG7) has been on a protracted selloff over the last six weeks moving from an intra-day high of $1,338/oz on November 9 to a low of $1,125/oz last Thursday.

With volatility relatively low, currently at 14.87%, investors could pick up some cheap ATM options and benefit from any short-term lift in the price of the futures. 

Here's how this trade could look like:

A vertical call spread using options on the active GCG7 using 1140/1170 strikes.

At the time of this writing the spread is offered at $12.10. This will give you a a breakeven of $1,152/oz and offer a ROR of 147%. 

Volatility gold
Source: QuikStrike

Volatility in WTI crude (CLG7) currently sits at 29.02% which suggests a movement between $48.31 and $57.53/b, 68% of the time.

This is a wide range that could support a number of strategies, among which a short strangle involving the above prices.

For those bullish and expecting further gains in the energy product could work a synthetic long position using futures options. 

LOG7
Source: QuikStrike

A synthetic long position in WTI could be established by selling short puts in the options market, while simultaneously purchasing a long call.

The combined position is intended to replicate a long position in the underlying futures. If you sold a put and bought a call ATM, you would have a delta on the combined position of 1.0 or 100% coverage of the underlying. 

Instead of using the ATM options, however, you could sell the 50 puts for $0.71 and purchase the 55 calls for $0.66 giving you a net credit of $0.05 and roughly 50 deltas.

This is, of course, a bullish strategy and the trade would benefit from the underlying price moving up. 

Going into 2017

There seems to be plenty of uncertainties going into the new year. What if the President-elect Donald Trump doesn't follow through on his campaign promises? What about rates moving up?

Is this going to cool off the housing markets and with it consumption? What about valuations? Valuations in the S&P 500 seem to be near all time high, as my colleague Peter Garnry pointed out in his blog earlier today.

As traders we need to adapt to new environments. As markets change, we need to change our approach.

These may be simple adjustments, such as using stop losses, reducing positions, using options to improve your odds and extract a dividend simply protecting your nest egg. These are all steps we could take. Using options can help you accomplish these.

Protecting your nest egg

A flexible collar can help you transition yourself out of the market for little or no cost. A collar will work best when you have a neutral to bearish view on the market.

An investor will sell typically 3% OTM call option and with the premium would buy 3% OTM put with same expiration, for little cost or no cost. 

Using the E-minis

For instance, if your equity portfolio consists of mostly of US large cap stocks, you could hedge the portfolio very effectively with equity index futures such as the E-minis S&P 500 (ESH7).

As with any other product or item, it's important to read the product guide and understand what is it that we are controlling by buying or selling one contract of the underlying future. See here.

At present level of 2260 one underlying E-mini future has a notional value of approximately $113,000 ($50 multiplier).

If you decided to protect your $500,000 portfolio you would sell four of the March '17 expiration (ESH7).

The underlying futures as well as futures options offer plethora of opportunities for hedging. The underlying has Wednesdays and Weekly options which you could use as well. 

Using volatility to hedge

If you decided to diversify you could use the CBOE Volatility Index (VIX) and use the options or futures on the index. For more info, please visit here.

Since there's a negative correlation between volatility and equity prices, the VIX will go up while equities go down.

SPX daily chart

VIX vs SPX
Source: Saxo Bank - create your own charts with SaxoTrader. Click here to learn more 

Trading VIX, however, could be a little more complicated and will require a closer look at volatility itself.

Is the implied volatility of the options I am buying significantly higher than the historical volatility? The implied volatility is the market's estimate of the future volatility of the underlying. So you don't want to overpay.

To gain upside exposure in VIX you could either buy an outright call or do it in a combination with another option.

At the time of this writing VIX is trading at $11.70. If you expected that volatility will increase over the next month you could purchase a $17 call for $0.90.

Your upside will be unlimited while your risk is the premium paid. The same could be done using a bull call spread on VIX, especially if you have not established the position before the VIX move.

The January 2017 17/22 call spread could be bought for roughly $0.50. This could provide someone with a potential to make $4.50, if the VIX closes at 22 or higher at expiration.

If you expected the VIX to grind sideways, you could sell a short strangle or short vertical spread for a capture some premium. Weeklys could work well due to the rapid time decay.

Some important considerations

Whatever you are view of the market going forward might be, you should consider using futures and options to diversify and protect your portfolio. 

You should take time to investigate every single product/strategy before employing with your capital. Look for liquidity, sell options when the VIX is high and buy options when volatility is low. 

Use your long (stock) positions to reducing your cost basis and reduce the risk. The lower the cost basis, the greater the opportunity of success in that investment.

Happy holidays!

-- Edited by Adam Courtenay

Georgio Stoev is futures and options product manager at Saxo Bank

Find more views on contract options here

3y
Klauss Klauss
One of the best articles and recommendations for 2017 in terms of hedge and investment strategies. congratulations.
3y
Klauss Klauss
One of the best articles and recommendations for 2017 in terms of hedge and investment strategies. congratulations, Georgio Stoev
3y
Georgio Stoev Georgio Stoev
thanks Klauss..
3y
Klauss Klauss
Done! ;)
3y
Market Predator Market Predator
Very nice.
3y
martinluchon martinluchon
Muchas gracias , un artículo muy didactico y para estudiar.
3y
Georgio Stoev Georgio Stoev
De nada Martin!
3y
Georgio Stoev Georgio Stoev
@Klauss, GCG7 starting to move:)

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