2017 was a great year for bulls and vol sellers: so good, in fact, that cross-asset volatility dropped to never before seen levels while making millionaires out of former Target managers who "sell vol for a living", while the Dow Jones Industrial Average ETF (DIA) posted one of the best volatility adjusted returns last year of the ETFs in Goldman's universe, closing +28% (S&P500 +22%) on a realized vol of 7%, in line with the S&P500.
However, according to a just released report by Goldman's derivatives strategists Katherine Fogarty and John Marshall, the clam appears to be ending, and the options market is now pricing in higher volatility in the fund as well as in junk bonds, the S&P 500, consumer and tech stocks.
Meanwhile Gold, E&P, and Biotech stocks are pockets of the market where option investors expect a similar level of volatility in 2018 as seen last year.
Some more details from Goldman:
- What parts of the market do option investors expect to make n bigger moves in 2018? Coming off extremely low realized volatility in 2017, the options market is broadly bracing for a pickup in volatility this year. At the ETF level, the options market is most focused on the potential for volatility to move higher in Index, High Yield, Consumer and Tech stocks.
- Where do options investors expect volatility to be more consistent with 2017? Gold, E&P, and Biotech stocks are pockets of the market where options investors expect a similar level of volatility in 2018 as seen last year.
- Where do options markets expect the biggest moves to come from in 2018? While the option markets are generally taking a more conservative stance on the cadence of volatility for high volatility assets in 2018, they are still expecting the biggest moves to come from Gold (GDXJ +/-27%), Oil (OIH +/-23%) and E&P Stocks (XOP +/-23%). At the stock level, while option investors are positioning for the average stock in the S&P500 to trade +/-22% over the next 12 months, they are expecting certain stocks to realize double or more this volatility:
What does this relative skew mean in terms of bullish or bearish directionality: here is Goldman's answer:
- Where are option investors positioned BULLISH for 2018? Option investors are pricing in an unusually low premium for puts relative to calls in Oil (OIH), Staples (XLP), E&Ps (XOP) and Financials (XLF). This suggests they are less worried about downside risks and positioned for further upside potential this year.
- Where are option investors positioned BEARISH for 2018? Option investors are paying an unusually high premium for out of the money puts in High Yield (HYG) and S&P500 (SPY) relative to calls. We note the higher skew in popular hedging instruments (HYG and SPY) could be a sign that investors are increasing their portfolio hedges given the low volatility environment.
Directional bias aside, according to Goldman's calculations, this is where the options market expects the biggest ETF moves in 2018: Index vol as well as High Yield, Consumer and Technology vol in 2018, and as Goldman adds, "coming off of a very low base of volatility realized in 2017, it’s notable that the options market is pricing in elevated volatility levels for 2018 for the vast majority of the US ETFs we monitor." Some more details:
Here are the 4 key categories where Goldman sees abnormal volatility going forward:
- The Dow Jones Industrial Average ETF (DIA) returned 28% last year (on realized vol of 7) yet the options market is pricing in that the ETF generates less than half of the return in 2018 on double the volatility (11% / 14.3%, respectively).
- High Yield option investors are also pricing in elevated volatility potential, as well as high level of concern, as suggested by elevated normalized put-call skew levels across tenors. As an example, iShares iBoxx $ High Yield Corporate Bond ETF (HYG) returned 6% last year on a realized volatility of 4. The options market is pricing in the potential for the ETF to trade up or down 7% by January 2019 expiration on a realized vol of 7, double the realized volatility of 2017. A similar setup is seen in the SPDR Barclays High Yield Bond ETF (JNK).
- Consumer Discretionary ETF investors are also positioning for higher volatility in 2018. XLY returned 23% in 2017 on a realized volatility of 8%, generating among the highest Sharpe ratios in our universe. Option investors are pricing in that the XLY returns +/-13% by January 2019, yet realizes a volatility that is 73% higher than what we saw in 2017.
- Options on Technology focused ETF QQQ and the Technology Select Sector SPDR Fund (XLK) are both pricing in the potential to return substantially less returns in 2018 than in 2017 yet the options market is expecting higher volatility for both. January 2019 $160 straddles for QQQ cost 14%, suggesting the options market is pricing in the potential for the QQQ to close up or down by this amount by expiration. This is substantially less than the 33% return that QQQ posted in 2017 on a realized vol of 10%.
To summarize: "Option investors are pricing in BULLISH views in Energy, Staples, and Financials, but BEARISH High Yield and S&P500. We look to skew as a measure of sentiment, and compare 1yr skew today to levels seen over the past five years."