Managing Volatility-Aided Strategies in a Low Volatility Environment
Alternative Team Perspectives by David O’Donohue
June 26, 2017
There has been much publicity lately related to the low volatility market environment. For many investors, a lack of volatility is a comforting feeling. For some of our hedged strategies though, volatility plays an important role in how we manage portfolios and generate returns. This leads to the question “How do we manage volatility-aided strategies in periods of low volatility?”
First, it is important to separate index volatility from individual stock volatility. Often, when investors think about their investments and the markets, they ask a simple question. “Was the market up or down today?” While people tend to think of “the market” in monolithic terms, it is important to remember that investors are usually thinking of an index (e.g., the S&P 500) that is composed of a number of individual companies—each with unique opportunities and challenges.
Many times, the market will move largely in lockstep based on changing investor sentiment. Sentiment shifts could be led by economic data, political events, or even a presidential tweet. Recently, however, correlation has declined both among sectors and individual equities. This has dampened index volatility, even as some stocks and sectors have continued to experience large moves.
To put it very simply, let’s say that on a given day, half the stocks are up and half are down. These moves could cancel each other out and leave “the market” relatively unchanged. Even so, we could have a number of individual stocks with large moves, which could provide many potential gamma trades for our convertible arbitrage strategy. (For more on convertible arbitrage and an overview on gamma trading, read our blog.) An observer reading the paper the next morning may see the unchanged levels in various indices and think that not much has happened. Owners of individual stocks may see things quite differently, however.
Because our convertible arbitrage strategy relies on individual stock volatility rather than index volatility to provide gamma trading opportunities and price dislocations, the reduction in market volatility has had less of an impact on this strategy than it has on our covered call strategy, which relies more on index volatility. In general, we think of our covered call (collared) strategy as short volatility. We generally take in more premium from the calls we sell than we spend on our put protection, and the strategy performs best in a slow-grinding upward market that often coincides with low volatility periods. Therefore, the strategy has tended to work well during the transition phase from a normal volatility environment to a low volatility environment. (Our calls decrease in value while our equities might slowly rise.) However, if low volatility persists once we get past the transition phase, we often adjust our focus.
One of the guiding principles of our market neutral income and hedged equity income strategies is to take advantage of the opportunities the market presents, not the ones we hoped it would present. In normal markets, we are able to generate income from our option hedge as the money we take in selling calls can exceed the money we spend on puts. This becomes challenging or impossible with index volatility at historic lows. That said, any time we find ourselves talking about “historic” levels, there are often opportunities as well.
For strategies like ours that rely on providing downside protection, the opportunity presented in environments like these is clear. Just as the price of the calls we sell is lower, the price of the puts we need to buy is lower too. This allows us to add more hedge through puts than we would normally be able to purchase. Similar to a shopper at a store, with the price of downside protection low, we can afford to stock up. We need to manage the cost of that in conjunction with the decreased income we discussed earlier, but the lower cost can allow us to be more hedged should this period of complacency end with a downside move.
If environments like this persist, we will continue to focus on capturing individual equity volatility in our convertible arbitrage strategy, while aggressively monitoring our option income/spend. Also, as always, we are working to identify and take advantage of opportunities the market presents. Although it may limit our income, a reduced call overwrite combined with increased put protection can leave us positioned favorably whether this current low volatility environment is just a pause before the next leg of a continued bull market or simply the calm before the equity storm.
Alternative investing strategies, such as gamma trading, are not appropriate for all investors. The value of a convertible security is influenced by changes in interest rates, with investment value declining as interest rates increase and increasing as interest rates decline. The credit standing of the issuer and other factors also may have an effect on the convertible security’s investment value.
Convertible arbitrage and gamma. Convertible arbitrage is an investment strategy that generally involves a long position on a convertible security and a short position on the issuing company’s common stock. A long position is the buying and holding of a security and a short position is the selling of a security that the seller does not own. Eventually, the seller must purchase the same security (hopefully at a lower price) and return it to the owner. Convertible arbitrage seeks to take advantage of dislocations in the value of a convertible security and its underlying equity. Theoretically, as the price of the underlying stock rises, the convertible value rises, and as the stock value falls, the convertible value falls as well. How much the convertible value rises or falls for a given stock move is referred to as delta. The change in delta as stock price moves is referred to as gamma.
Covered call writing is an options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset in an attempt to generate increased income from the asset. The strategy also allows for the purchase of put options on individual securities and indexes to protect principal against downside moves in the equity market.
Convertible Arbitrage Principal Risks: Convertible Securities Risk-The value of a convertible security is influenced by changes in interest rates, with investment value declining as interest rates increase and increasing as interest rates decline. The credit standing of the issuer and other factors also may have an effect on the convertible security’s investment value. Convertible Hedging Risk- If the market price of the underlying common stock increases above the conversion price on a convertible security, the price of the convertible security will increase. The portfolio’s increased liability on any outstanding short position would, in whole or in part, reduce this gain.
Short Sale Risk: A portfolio may incur a loss (without limit) as a result of a short sale if the market value of the borrowed security increases between the date of the short sale and the date the portfolio replaces the security. The portfolio may be unable to repurchase the borrowed security at a particular time or at an acceptable price.
The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.
This material is distributed for informational purposes only. The information contained herein is based on internal research derived from various sources and does not purport to be statements of all material facts relating to the information mentioned, and while not guaranteed as to the accuracy or completeness, has been obtained from sources we believe to be reliable.
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