6 catalysts for volatility, and how to play it

Implied volatility is now trading at record lows across a variety of asset classes, especially in US equities. This means that option markets are priced in the belief that the economic and political outlook in America and the world is as stable as it has been for more than 25 years.

We believe the recent period of global financial stability will end, possibly quite dramatically.

6 reasons for this belief include:

1. There is much that could go wrong in global politics, especially when the US is led by Trump.
2. The world, especially China, has a lot of debt. We don’t understand China well enough to know if its financial system is highly vulnerable as some people argue, but we regard this risk as very real. High debt levels make individuals and the financial system more vulnerable to shocks, including higher interest rates, which are inevitable (but probably not soon).
3. There are US funds that specialise in different option selling strategies. These funds have generated very good returns and are attracting significant new money. We recently observed the creation of a retail fund whose strategy is to sell put options. This flow of new money has pushed option prices down further as those funds are forced to sell the options that they were established to sell. If markets become more volatile, those funds will rapidly lose a lot of money and some might be forced to cover their positions as investors respond to large losses by withdrawing their remaining capital.
4. Some investors have also been attracted to selling options as a way to generate “income” in an environment where it is difficult to find safe ways to generate high income. In general, taking added risk to boost one’s income is a dangerous strategy. It adds to our enthusiasm for option buying to know that much option selling is, in effect, being done by ill-informed retail investors chasing income and hot recent returns.
5. A high proportion of US equity market ownership and trading involves investors with very short-term time horizons and various forms of leverage. These factors add to instability when markets become unstable.
6. The key point is that option bets are a gamble with attractive odds. If future volatility is similar to historic volatility, then our September options position has an expected value about 180% of the price we paid. If future volatility is in line with the recent actual low volatility, then the expected value of the bet is about 80% of what we paid. Although options have inherent obvious risk, this combination of the bet having an expected value of 180% if we’re right and 80% if we’re wrong is very attractive.

How we plan to profit if volatility picks up

Our bet takes a view on volatility picking up, and consists of buying call and put options on the index with the same strike prices and maturities. For example, we own both call and put options exercisable at 2470 until 15 September. The combined cost of these options in July was 60 points, meaning that to make a profit on this trade, the index needs to either fall below 2410 or rise above 2530.

Why we think the US bull market could accelerate

Despite our many worries about the world, we think it quite probable that the S&P Index has not yet peaked. Indeed, we think that the US market could accelerate its rise. In our previous Livewire post, we outline three reasons why, and one way to trade it:  (VIEW LINK)

Samuel Terry Asset Management Pty Limited (AFSL 278294) does not guarantee the repayment of capital or any particular rate of return from the Trust. Past performance is no guarantee or indication of future performance. The unit price can go down as well as up. The above report does not take into account a reader's investment objectives, particular needs or financial situation. It is general information only and should not be considered as investment advice and should not be relied on as an investment recommendation.

If you are thinking of buying options, we remind you that there is a high probability that you will lose most or all of your investment. Options are an unsuitable investment for most investors.