One of the largest potential volatility events for the equity markets this year will be the Q1 US Debtapalooza. There are three main issues that are to be debated with a crescendo coming in late February – the Long Term Budget Deal, the 2013 Budget Deal and the Debt Limit. There will obviously be many consequential threats and theatrics associated with these events – including potential threats for government shutdowns and debt defaults – while the very real consequences could be additional US ratings downgrades. It is important to remember that outside of the 2008 shock, the Debt Ceiling Debate and consequent US Debt Downgrade in Summer 2011 created the biggest volatility event of the past two decades.
Volatility metrics show that the market is extremely complacent heading into these events. Equity volatility and skew are trading near multi-year lows (5th percentile or less over past two years), while many market indices are making new multi-year highs. From a positioning standpoint, net exposures are higher than any time in 2012 while hedges are at multi-year lows. Total SPX Put Open Interest has fallen from 9.5mm contracts to 5.7mm contracts in the past month – This is the lowest level of puts outstanding for the S&P500 since June 2009. The bottom-line is that we are heading into a potential multiple-standard deviation volatility event with the price of options at their lows and market exposures/equity prices at their highs.
Below, we look at 3Q11 changes in price, front month put implied volatility, and 90-day realized volatility across asset classes to assess the best hedge for the upcoming debt ceiling debate. We highlight some of our favorites – IWM puts, VIX call spreads and HYG puts – but lay out the full list below.
1) IWM Puts -- Beta underperforms when the market gets volatile. Summer 2011 saw IWM fall 22% vs the SPY falling 14%. However, the current volatility premium of IWM over SPY is only 3 vol points – which means you can get IWM beta on the cheap. Currently IWM is trading on a 17 vol – in 3Q11 it rallied from 20 vol to 49 vol. This means you not only won on deltas, but you had a vol explosion. IWM March 82 puts for $1.30.
2) VIX Call Spreads – Given its convexity, VIX knocks the competition out of the water when it comes to panic moves in the market. VIX rose 160% during 3Q11. VIX volatility is now trading at two year lows, which makes upside call spreads look interesting. This could also be a good play on a run-up in volatility ahead of sequester/budget talks – similar to what took place at the end of the year ahead of the fiscal cliff. VIX March 20-30 Call Spread for $1.30.
3) HYG Puts – The High Yield ETFs have seen one of the largest price appreciations/inflows since Summer 2011 (+15% in that time). The average junk yield is now below 6% and the space seems crowded and susceptible. HYG protection has fallen dramatically-- Put Open Interest fell from 270k contracts to 150k contracts in the past month as almost all fund protection was centered in December 2012. HYG options are trading on a 6 volatility –implied vol got to over 18 and HYG fell 8% in 3Q11. HYG March 92 Puts cost $1.05 – a 3% break-even.
3Q11 changes in price, front month put implied volatility, and 90-day realized volatility across asset classes
S&P 500 Realized 15-Day Vol - August 2011 was a massive event...
Charts: Jefferies and Bloomberg