As we have pointed out numerous times, Goldman notes that elevated US policy uncertainty and geopolitical risk indicate heightened risk of more frequent political and geopolitical tail events, in the form of both ‘known unknowns’ or ‘unknown unknowns’...
And given the extreme complacency in markets, Goldman suggests the following trade as a clean way to play that concept of reality emerging into market pricing once again...
Which equity option strategies work in low volatility markets?
While systematic call overwriting usually helps improve asymmetry of equity returns, in low-volatility periods with markets trending up slowly, such as in 2014 and right now, overwriting becomes a drag on returns. This points to cash extraction, i.e., replacing existing equity positions with ATM calls. Also, buying OTM puts seldom pays off given that low volatility periods can last and 1-month drawdowns are often not large and long enough to move into the money. Even in cases when the market fell the most from low levels of volatility, it rarely fell more than 5% in the subsequent month. Hedging with OTM puts mainly pays when moving into a higher vol regime, which is when the market tends to have larger and more prolonged drawdowns – on average buying puts was a drag on returns in low vol periods. Collars (long OTM puts funded by calls) can reduce the negative carry, but again they are most likely to work in larger equity drawdowns that occur in high vol regimes.
Steep vol term structures point to very short- or long-dated calls
Volatility term structures are very steep right now (Exhibit 49), which is common in low vol periods when short-dated vol is pulled down by low realised and longer-dated reflects medium-term concerns about higher vol. In part, they also reflect elevated policy uncertainty.
As a result, investors should focus on shorter-dated options (1-month) or longer-dated (2-year+) to mitigate the negative rolldown.
To manage equity drawdown risk, we particularly like longer-dated call options for multi-asset portfolios – in Europe and Japan, where option premia are low due to low forward prices and long-dated vol is anchored due to structured product flows. Along a similar vein, convertible bonds are an asset class that tends to become more attractive in low vol periods due to their embedded longer-dated equity options and comparably low duration risk.
Elevated skew points to put spreads
For the S&P 500, skew (the cost of puts vs. calls) is close to all-time highs.
This reflects in part more restrictive regulation for banks but it could also again reflect the increased policy and geopolitical uncertainty, coupled with the US moving more late cycle. For EURO STOXX 50, skew has also increased sharply recently. However, this makes puts more expensive.
We like put spreads to protect from tail events and from an end to the current low vol period and a shift towards higher volatility regime – a S&P 500 97-93% put spread would currently offer a 25x payout in the event of a 7% drawdown.
Owing to volatility clustering, ex ante the probability of a 93-97% put spread having a positive payoff from current low levels is relatively low (c.5%). But we think it is an attractive, low cost tail risk hedge for a multi-asset portfolio at this stage, before moving into a more persistent high vol regime. The last time 97-93% put spreads were priced as low was in 2007 and 2014.