Salomon derivatives group suggests buying S&P volatility

By Ronda Fears

Nashville, Tenn., July 25 - The Salomon Smith Barney derivatives group suggests in a report Thursday that convertible hedge funds sell European volatility and buy S&P volatility amid the current spike in blue chip volatility that has moved puts on U.S. convertibles into the money.

Over the past couple of years, new issues of 0% coupon convertibles have had a large effect on the volatility market, noted group head Leon Gross and salesmen Ryan Gould, Olivier Sarfati and John Chiang in the report.

These convertible issues consisted of companies selling huge quantities of out-of-the-money calls, which lowered the implied volatility of the market and also had a effect on the realized volatility.

"Implied and realized volatilities in Europe and the U.S. are reaching levels reached only in previous global crises. Unlike previous crises that originated outside of the blue chips and affected the blue chips, this one is a blue chips crisis," the report said.

"Implied volatilities are up because the realized has been high, and the market is lower and because of the smile, a lower strike is at the money, and these strikes always have had higher volatilities. The increase in the implieds is not due to large scale buying of volatility."

With the move downward in the U.S., convertibles have moved out of the money, and the puts in collars have moved in the money, so that the Street's position has switched from long volatility to short volatility, it was noted. Also, with less corporate put sellers, supply has dried up.

"Since the market is down so much the options in these converts, that were issued 30 to 40% out of the money, are now much further out of the money. Most of these options are so far out of the money that they have very little vega or gamma, and have almost no effect on the market," the report said.

"Many of these convertible bonds are now nearing junk or distressed levels, which means that the bonds start to trade with negative curvature, as decreases in the stock price causes an increasing probability of default."

The group noted that from a framework that looks at equities as a call on assets minus liabilities, corporate bonds are short a put on assets minus liability and consequently are short vega and gamma, which starts to matter when the bonds begin to pick up market exposure.

In Europe, collars traded recently now have puts in the money.

"Although Europe is much more volatile than the U.S. on a daily basis, on a longer-term basis, the returns are almost the same. The implieds are in line with the daily volatility, so we recommend selling European volatility and buying daily volatility," the group said in the report.

"For this trade we recommend not hedging at all, hedging weekly, or hedging at the same time in U.S. and Europe. We recommend selling European volatility and buying S&P volatility, either in equal notional if options are used, or equal vega if volatility or variance swaps are used. This position will take in a very large volatility credit as Eurostoxx vol is much higher than S&P volatility.

"One strategy is not to hedge at all with the view that over the long run European and U.S. returns are similar. For those who wish to delta hedge, instead of hedging the U.S. at the U.S. close and Europe at the European close, we recommending delta hedging at the same time. This means hedging weekly, and picking a time when both markets are open, or by hedging once a day when both markets are open."

Most of the increase in at-the-money volatility has occurred because the markets are lower and lower strikes with higher volatilities are now the at-the-money options. The actual implied volatilities of each strikes have only gone up a few volatility points. The surface itself moving up only accounts for about one-third of the increase in volatility, the other two-thirds comes from moving down the smile.

The term structure is downward sloping, which is consistent with the smile effect. The longer dated smiles are flatter, so the same move down in the market has a smaller effect on the at-the-money.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.