Volatility plays an important role in how we manage some of our hedged strategies and generate returns. This has led to the question “How do we manage volatility-aided strategies in periods of low volatility?”
Because our convertible arbitrage strategy relies on individual stock volatility rather than index volatility to provide gamma trading opportunities and price dislocations, a reduction in market volatility can have less of an impact than it has on our hedged equity 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 slowgrinding 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 like we saw in 2017. 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 low volatility environments 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 a period of complacency end with a downside move.
If the low volatility persists, 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 the low volatility environment is just a pause before the next leg of a continued bull market or simply the calm before the equity storm.
For more information, see:Return to the Volatility Guide
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Senior Vice President, Co-Portfolio Manager