“The real value of TRH strategies is derived from the efficiency with which they provide these leveraged upside payoffs. In other words, the cost side of the equation must be minimized relative to the upside.”
-Aaron Brask
For some added color on the quote above, it was a snip-it from a more tactical discussion on implementing "Tail Risk Hedging" in a recent white paper: Tail Risk Hedging: An alternative Approach to Risk Management
The bottom line is that TAIL risk hedging is going to be costlier at certain times over others.
Brask goes on to say:
“Derivatives markets have a tendency to price risk (options and implied volatility) according to trailing observations (realized volatility).”
If you’ve followed us for more than a week, you know that we try to find ways to analyze and exploit this market reality.
Taking commercial hedgers and more delta-neutral market makers off the table, here’s a rhetorical question we would ask:
Of the systematic and discretionary strategies that supplement their underlying portfolios with options, how many of those managers would put a heavier weight on the directional hedge over the price of volatility?
Back to the Global Macro Grind…
For a more explicit explanation of the rhetoric, here’s an example…
Stock XYZ has event risk coming. Manager X does not want to be on the wrong side of this event. He is long and wants to hedge that position. Our hypothesis is that the manger is often much more focused on hedging the underlying directional risk of the stock than analyzing how much the insurance costs.
Ahead of Amazon earnings after the close today, the volatility assumption backed out of At-The-Money options for indices like the Nasdaq 100 (QQQ) or Information Technology (XLK) has been pushed to 5yr highs. In other words, investors are extremely worried about what the Amazon earnings event may do to some of the major indices and demand for protection has gone through the roof.
While our macro team is not making a big call on the Amazon quarter, this is an example of the forward-looking market color gleaned from derivatives markets. The behavioral shift in sentiment toward some of the 2017 market darlings has been swift and ongoing.
If you were willing to sell volatility with delta-neutral positions or spreads that capture the massive demand for at-the-money volatility exposure, this would be the place if you had a view. We have a volatility surface out of whack that will return to a more normal shape tomorrow pending the print post-close. This volatility set-up is a good example of deep pockets either “knowing something” or taking the “hedge at all costs” route which is probably driven by overall market anxiety.
To the extent you’re interested, below we provide more technical color of the “Amazon effect” on tech sector volatility expectations. Please reach out with any comments or questions.
Implied Dispersion: This is a wonky term that can be easily simplified. It’s a factor that measures where volatility trades at the sector level relative to the index (at-the-money). Implied volatility the tech sector (XLK) is currently 5-6 standard deviations wide from SPY on a TTM and 3Yr time window.
Volatility Skew: The volatility surfaces in tickers like XLK and QQQ show that much of the hedging activity has taken place at and around last price. At-the-money put implied volatility in XLK closed the day yesterday trading well above the TAIL risk strikes which is a rarity - we know that equity markets almost always exhibit steep put skew.
Chart of the Day: The chart contextualizes the 5Yr highs in at-the-money implied volatility for the tech sector by comparing 30-day and 60-Day durations for volatility exposure relative to the SPY index.
Our immediate-term Global Macro Risk Ranges (with intermediate-term TREND views in brackets) are now:
UST 10yr Yield 2.77-3.07% (bullish)
SPX 2 (bearish)
RUT 1 (neutral)
NASDAQ 6 (bearish)
Nikkei 215 (bullish)
DAX 124 (bearish)
VIX 14.52-19.48 (bullish)
USD 89.80-91.25 (bullish)
EUR/USD 1.21-1.23 (bearish)
YEN 107.19-109.61 (bearish)
GBP/USD 1.39-1.42 (bullish)
Oil (WTI) 65.88-69.50 (bullish)
Nat Gas 2.63--2.85 (neutral)
Gold 1 (neutral)
Copper 3.02-3.16 (bearish)
Good luck out there,
Ben Ryan
Macro Analyst
