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.