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Whether Vol is High or Low, Gamma Trading Can Exploit Opportunity
Alternative Team Perspectives by Jason Hill
February 28, 2018
In 2018, volatility kicked into high gear. So far, there have been 11 days when the S&P 500 has moved at least 1%. Investors may not like the return of volatility, but it can strengthen the tailwinds for the gamma trading we do in our market neutral income strategy (see our previous blog for an overview of gamma trading). The more volatility in the market, the more stocks rise and fall—which can give us more opportunities to sell high and buy low.
But, what if volatility declines again or stays at more normal levels? The good news is that gamma trading is a versatile strategy. In an environment like 2017 when overall market moves were at a minimum (the S&P 500 had only eight 1%+ moves in total), one might assume there were limited opportunities for us to profit from gamma trading. Although we did see somewhat muted convertible arbitrage returns because of the low vol environment, low volatility in the S&P 500, VIX and other major indexes does not always mean low volatility for individual stocks.
We can still find many gamma-trading opportunities even in low volatility environments:
- 1. Sector rotations and individual stock volatility versus index volatility. For example, if the market is experiencing a sector rotation, Utility Stock A could be down 10%, while Tech Stock B is up 10%. Individually, these are very large stock moves, but if Stock A and Stock B were in the same index, their moves would cancel each other out, in theory. So, while there could be a major sector rotation going on along with substantial single-stock moves, overall index volatility could still be very low.
- 2. Company-specific events. Companies release earnings throughout the year and this creates many opportunities to trade. It is common to see greater than 2 or 3 standard deviation moves following earnings releases as well as other company-specific events and announcements.
- 3. Smaller market-cap companies. Small and mid sized companies represent about half of the U.S. convertible market. These smaller market-cap companies typically have higher historic and forecasted volatility levels than larger cap stocks.
While we’ve seen index volatility snap back in a major way during early February (with the VIX up more than 65% year to date through February 23), it is important to remember that gamma trading can be profitable in many different market environments and does not rely solely on elevated broad market volatility.
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.
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.
The VIX (CBOE volatility index) is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. The S&P 500 Index is considered generally representative of U.S. stocks. Indexes are unmanaged, do not include fees or expenses and are not available for direct investment.
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.
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