Implied volatility levels for out of the money put options have not fallen as sharply as those for at the money puts during recent weeks, and this has made protective hedging trades such as short-dated put spreads attractive for those investors who believe "markets cannot go up forever", according to Macro Risk Advisors.
Implied volatility levels for out of the money put options have not fallen as sharply as those for at the money puts during recent weeks, and this has made protective hedging trades such as short-dated put spreads attractive for those investors who believe “markets cannot go up forever”, according to Macro Risk Advisors.
The US-based firm specializing in risk analysis and volatility trading spoke before Thursday, when worse-than-expected German and French economic data sparked fears of a double-dip Eurozone recession, suggesting investors who believe markets cannot rise indefinitely may be proven right – and soon.
Dean Curnutt (pictured), Macro Risk Advisors’ CEO, said: “We think at the moment investors should consider buying short-dated put spreads.”
He pointed to a recent “collapse” in the Vix index of expected near term S&P 500 volatility, and falls in the related at-the-money volatility SPY with a 138 strike price one or two months out, compared to the relatively milder falls in out-of-the-money volatility puts with strike at 133.
Put-spreads involve buying at the money put options, while simultaneously selling out of the money put options, which Curnutt said currently gives holders “a nice configuration of volatility.
“As an insurance policy, the payoff of a put spread is capped and if there is an unforeseen negative event to the market, it will only provide so much protection. But we believe we are in a market right now where the volatility level is going to remain reasonably low.”
Those investors who bought mono-directional hedges based on volatility back in times when they expected markets to fall and volatility to jump sharply, have paid a high cost to hold (‘carry’) those hedging positions without much return, as markets have behaved far better than the surrounding macro environment might have suggested at time of purchase.
“The economics of hedges had become really unfavourable in the latter part of the past two months, with a significant gap between the Vix – and the actual level of volatility in the market. This gap puts downward pressure on option prices.”