In recent weeks, concerns about the health of the global financial sector caused a spike in equity market volatility. VIX, the US S&P500 volatility index, rose sharply from below 20% to the 30% level which is seen by many investors as an attractive level to sell volatility to generate income.
No doubt, many investors would be interested to know 1) whether we will see further volatility in the markets and 2) if there are technical factors that would exacerbate the uncertainties in market fundamentals.
In terms of technical factors, over the past few months, investors have been positioning for higher volatility by buying call options on the VIX. Now, dealers, having sold such call options to investors, would need to hedge out their positions by taking the opposite position. That is because dealers capture the spread, instead of making directional trades. Hence, they would need to buy VIX futures to neutralise their exposure. If there were to be a sharp spike in the VIX-index, these dealers would need to buy more VIX futures, exacerbating market volatility!
The other technical factor is the rise in popularity of “zero-day-to-expiry” daily and weekly options, with daily notional volume at USD 1trillion per day. Essentially, these are options which are out-the-money and about to expire. Typically, investors sell such put options for yields, which means dealers are long put options, and would need to buy S&P 500 index futures to hedge their directional exposure. If the market falls sharply, dealers make profit on their long put option positions, and these expire frequently as they are extremely short-dated. Then dealers would be left with ‘naked’ long S&P 500 index futures in their hedges, which they may need to rush to sell if the market continues to fall fast. Again, this exacerbates market volatility!
These technical factors are not the drivers that can explain from a fundamental standpoint why the market falls. However, they can “fuel the fire” when the fire is already going – that is, they may cause the markets to fall even further than what is indicated by the fundamentals, resulting in a “self-fulfilling loop” with downward spiralling prices.
On a 6-12-month horizon, the current issues in the financial sector are likely to complicate an already difficult economic landscape confronting the Fed and the ECB. Banks, especially the small and mid-sized lenders, are likely to further tighten lending conditions. Meanwhile, inflation is still running high, which implies we may be in for a period of “higher for longer” interest rates. Such an environment may lead to weakening corporate earnings and profit margins, which could result in higher volatility in the medium-to-long-term.
We expect market volatility to stay elevated, or perhaps even go higher, in the coming months. As a result, investors should follow a defensive strategy by adding to high-quality bonds, and extend the average maturity in their bond portfolios. And if the VIX index rises above 30%, there could also be opportunities for investors to earn attractive income by selling volatility through structured strategies.
Daniel Lam is Head of Equity Strategy at Standard Chartered Bank’s Wealth Management Chief Investment Office.
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