Last week, as part of its must read 2018 Outlook piece, Bank of America's derivatives team pointed out two particularly notable things: the first was BofA's version of the (central-bank mediated) "feedback loop" diagram that keeps volatility record low and grinding even lower, as selling of vol has become a self-reinforcing dynamic, in which lower VIX begets more vol-selling by "yield-starved investors", leading to even lower VIX as the shock that can reset the feedback loop is no longer possible, and thus the strike price on the Fed's put can not be put to a market test, which also results in even greater market fragility and assured central bank interventions...
... and a chart suggesting that the market generally broke some time in 2014, when the "behavior of volatility entirely changed, with volatility shocks retracing at record speed. Investors no longer fear shocks, but love them, as it is an opportunity to predictably generate alpha."
Now in keeping with the prevailing theme of the year, which for better or worse is the "paradoxical inversion" of everything, in its last report of the year, the BofA derivatives team looks not forward, but back, at the year that is almost over, and in an attempt to summarize the bank's volatility insights from 2017, has written:
"17 facts from ‘17 to remember for 2018"
First, here are the key takeaways from BofA's derivatives gurus:
- Extremes are everywhere when looking at markets through the lens of volatility.
- Despite low volatility, trading volatility as an asset class just keeps getting more popular.
- Use 2017 dislocations to your advantage in 2018 for cheap hedges, alpha and harvesting risk premia.
With that in mind, here's what BofA thinks you need to remember about 2017 for 2018 (highlights our):
- Global assets' record dependency on US rates make rising rates vol a key risk
- Sharpe Ratios near 80yr highs suggests using cheap options for equity upside
- Risk parity vol at its lowest in decades makes bond tantrum hedges cheap
- US equity trading ranges hit 110yr lows; look for vol bubble deflation in '18
- Buy-the-dip is alive and well as evidenced from record intra-day (vs daily) vol
- Equity instability at 90yr highs despite low vol, but can be hedged with VIX
- Extreme post-US election rotation crushed correlation creating opportunities
- Markets where we like owning vol are showing most signs of life in '17
- BOJ ETF purchases may peak in 2017, reducing impact on NKY vol in 2018
- Korean retail vol selling may have peaked in '17, lowering headwinds in '18
- Diversification benefit of owning vol as an asset is near record highs
- Record year for VIX volumes despite low VIX cements vol as an asset class
- 50% VSTOXX futs. growth shows it's a market of choice for trading EU risk
- VSTOXX futures may gain significantly as they wake up to Italian election risk
- 2017 vol crush left ESTX50 short-dated roll-down most attractive in history
- Rising popularity of S&P weekly options shows lack of long-term conviction
- Dispersion trumped geo-politics as the most popular research theme of 2017
And here are some additional details on BofA's top themes:
1. Global assets' record dependency on US rates make rising rates vol a key risk
The correlation of rate-sensitive assets to US rates is at record highs as investors fail to care about outside risks, leaving markets increasingly dependent on US policy. Coupled with rates vol near lifetime-lows - on few expectations for policy disruption - this has helped suppress global cross-asset vol. However, with the Fed appearing to soldier-on towards policy normalization, persistently low rates vol may be at risk. This in turn creates risks for a market slaved to rates. To monetize this, buy calls on dispersion on a basket of highly rate-sensitive stocks, which could benefit from a pick-up in rates volatility and/or a decline in component correlation if assets become less slaved to a common factor.
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2. Sharpe Ratios near 80yr highs suggests using cheap options for equity upside
In our 2018 year ahead, we focused on the question of whether 2018 is the year when we finally escape from this record vol depression or if this is a new normal? Our view is that this is not a new-normal, but a bubble. While one can debate whether risk assets like equities and credit are in a bubble, volatility is clearly there. As one piece of evidence, US equites generated near 80yr record Sharpe Ratios this year (4.3 for the Dow and 3.1 for the S&P500 and the Nasdaq100), not because returns were record high but because vol was record low. Given today's equity Sharpes are in "rare air", we continue to advocate using historically cheap options to capture upside without the need to time to top. Simply replacing upside equities with call structures for example makes sense. Or finding cheap puts on momentum stocks can create a synthetic long call position and provide more confidence to chase momentum.
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3. Risk parity vol at its lowest in decades makes bond tantrum hedges cheap
In 2017, multi-asset portfolios continued to benefit from equity/bond diversification. Low equity/bond correlation alongside record low cross-asset volatility is driving the vol of equity/bond risk parity portfolios to its lowest levels since the 1960s. Other multi-asset portfolios holding a mixture of equities and bonds have likely also seen extremely low volatility recently.
However, a disorderly rise in yields that accompanies an equity market pullback (i.e., 2013 Taper Tantrum) could be a surprise for many investors who have become conditioned to the recent environment in which bonds and equities diversify one another. Hedges for a bond tantrum are still cheaply priced as derivatives imply this risk is remote - consider buying SPX puts contingent on higher 10yr CMS rates or HYG (HY Corporate Bond) put spreads.
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4. US equity trading ranges hit 110yr lows; look for vol bubble deflation in '18
A less traditional depiction of the extreme low equity market vol we realized in the last year, both the S&P 500 (SPX) and Dow (INDU) traded in record tight trading ranges in 2017. Specifically, the S&P 12 day close-to-close trading range dropped to 0.32% in Aug-2017 (Chart 11) and the Dow 12 day close-to-close trading range fell to 0.47% in Mar-2017 (Chart 12), shattering 90 year and 117 year records respectively. While stock valuations are not at life-extremes, century-long records suggest volatility has reached levels that are unsustainable over the long term.
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5. Buy-the-dip is alive and well as evidenced from record intra-day (vs daily) vol
As highlighted in our 2018 outlook Risk is not fake news, investors no longer fear shocks but love them. Since 2013, central banks have stepped in (or communicated that they may step in) to protect markets, leaving investors confident enough to "buy-the-dip". In fact, the market rebounded so quickly after Brexit (3 days) that the Fed did not even need to step in, with dips progressively becoming shallower from then. This intra-day mean-reversion (in part driven by buy-the-dip behaviour) has translated into record high intra-day realised vol relative to open-to-close realised vol. While this effect was particularly stark for US equities (Chart 13), it is also true for Europe and Japan.
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6. Equity instability at 90yr highs despite low vol, but can be hedged with VIX
looking at the long-term history of the S&P500, 2017 stands out for generating an unprecedented number of 5? 1-day SPX drawdowns, suggesting US equities are unusually fragile today by historical standards. Our favorite "fragility" hedge entails going long VIX 1M 50-delta calls vs. short VIX 2M futures on a 1:0.85 ratio as a way to hedge a VIX singularity with low carry. Why? Funding VIX calls via rich term structure risk premium can (i) carry flat in quiet markets and (ii) unlike many other flat-carry hedges, provide attractive convexity benefits in shocks that come with little forewarning. The trade leverages both curve flattening/inversion and a spike in vol of vol - common features of the "fragility" events witnessed in recent years.
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7. Extreme post-US election rotation crushed correlation creating opportunities
Record sector rotation since the US election has driven inter-sector correlation to multi-year lows, as markets continue to differentiate between perceived winners and losers under the Trump administration. Indeed, the average pairwise 6m realized correlation between the 10 GICS sectors in the S&P500 is at levels last seen during the dotcom bubble (albeit amid significantly lower realized vol). Going forward, this creates opportunities like buying hedges that harvest depressed correlation/volatility (e.g., best-of-puts) or monetizing the implied-realized correlation risk premium via vega flat dispersion.
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8. Markets where we like owning vol are showing most signs of life in '17
With global equity volatility near multi-year lows in 2017, we note that volatility is still off 37-year lows in US small caps (RTY) and the NKY, while other markets including SPX are at life-lows. As highlighted in our 2018 year ahead, Risk is not fake news, we continue to like vol "decompression" trades through owning longer-dated realized vol spreads between NKY, RTY, and SX5E vs. SPX, as they carry flat to positively but should benefit from rising risk. US small cap realized volatility in 2017 is supported by the expectation of a tax reform and the NKY realized volatility is supported by the unexpected break-out of the index in 3Q 2017.
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9. BOJ ETF purchases may peak in 2017, reducing impact on NKY vol in 2018
While, not the dominant driver of NKY vol this year, the BoJ has enlarged its ETF purchase program to ¥6trillion in 2017 and we estimate that the program depressed the current equity 6-month realized volatility by 0.8 volatility points (or 9% of its current realized volatility). With the trend of policy tightening globally, the BoJ may change the wording of its ETF purchase program in 2018 to enable stealth tapering.
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10. Korean retail vol selling may have peaked in '17, lowering headwinds in '18
With a strong market rally and global rates remaining at relatively low levels, Korean structured product issuance is expected to hit a new all-time high of US$55bn in 2017. The substantial amount of volatility supply (>US$200mn vega) was one of the key drivers in pushing volatility lower this year. However, we expect to see headwinds in issuance amount from higher interest rates in 2018.
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11. Diversification benefit of owning vol as an asset is near record highs
On a 6m basis, the beta between VIX/SPX, V2X/SX5E, and VNKY/NKY each reached new records in 2017 as spot indices rallied and vol remained restrained. Hence the diversification benefits of owning volatility as an asset have been near record highs.
However, the beta between VHSI and HSI bucked the trend as its beta failed to reach a new record. During 2017, there were multiple instances where both HSI spot and HSI vol increased simultaneously, curtailing the beta ratio.
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12. Record year for VIX volumes despite low VIX cements vol as an asset class
Volume in VIX-linked products reached multiple highs throughout the year despite historically low VIX levels - trading over $1bn vega daily 12 times in 2017 vs. 7 times in total from 2004-2016. The all-time high of $1.9bn vega was set on 10-Aug-17. On the day, volume in VIX call and put options reached $250M vega and VIX futures traded a record $850M vega (with the vast majority of this volume in the front and second month futures). Similarly, volume in long unlevered, long levered, and inverse VIX ETPs reached an all-time high of $830M vega traded.
While we do not see the VIX market as large enough or levered enough to destabilize the broader US equity market, VIX derivatives are clearly the dominant market for trading global equity volatility today. Hence the nuances of VIX positioning are more important than ever to understand, as discussed in our 2018 Outlook.
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13. 50% VSTOXX futs. Growth shows it's a market of choice for trading EU risk
VSTOXX futures and options open interest and volumes reached record highs in 2017. Demand for VSTOXX derivatives - futures in particular - soared around the Apr/May-17 French elections, as it had done in the past around well-flagged political events like the Brexit vote in Jun-16 and US elections in Nov-16. Notably, while VSTOXX liquidity has significantly improved, it is still dwarfed by that of the VIX: average daily VSTOXX futures volume was EUR 5.2 mio vega in 2017, which is approx. 2% of the VIX (USD 256 mio vega, disregarding FX).
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14. VSTOXX futures may gain significantly as they wake up to Italian election risk
If history is anything to go by, the VSTOXX futures curve can reprice significantly going into well-flagged high-stakes events, as it did ahead of the UK's EU referendum (Jun16) and French elections (Apr/May 2017). While a reflection of Italian election risk (currently expected by mid-March 2018) was starting to emerge as early as mid Oct-17 in VSTOXX futures flies, the short 1xJan / long 2xFeb / short 1xMar fly has lost some steam recently. Arguably, uncertainty around the exact date of the vote may mean that the Mar future is also pricing some event risk.
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15. 2017 vol crush left ESTX50 short-dated roll-down most attractive in history
Equities have been remarkably quiescent in 2017 and set multi-year records in terms of how tight trading ranges have been. European equities set an all-time record (30yr history) in their 1yr max versus min price range (Chart 25). As a result, short dated ESTX50 volatility collapsed, leading to extreme steepening in the vol term structure. Chart 26 highlights how low volatility has been in 2017 versus 2016 (on average). It is interesting to note the contrast in term structure in 2017 (much steeper) vs 2005, which was the last time European equities were stuck in a range close to the same extent as now.
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16. Rising popularity of S&P weekly options shows lack of long-term conviction
Nearly 30% of all listed S&P 500 (SPX) options volume now takes place in options that are (i) short-dated, with expiries less than 2 weeks away, and (ii) close to at-the-money, with strikes between 98% and 102% of SPX spot.
In our view, this reflects the proliferation of S&P weekly option listings, which allow investors to express increasingly precise views, particularly around macro catalysts - but also a market that has become increasingly short-term in its focus, lacking longer-term conviction and wary of carrying longer-term positions. Additionally, historically low volatility has likely forced both premium sellers and buyers alike into options that are closer to at-the-money.
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17. Dispersion trumped geo-politics as the most popular research theme of 2017
Aside usual suspects like volatility, risk, etc., dispersion and hedging have been the most frequently referred themes based on our derivatives publication (GEVI) titles from 2017. This is in contrast to 2016 where key events like the Brexit vote and US elections dominated.