Benjamin Bowler from BofA Merrill Lynch and Michael Wexler of Maple Leaf Capital teamed up to discuss alpha opportunities in equity derivatives that arise from macro uncertainty.
Bowler starts out talking about the tremendous increase in volume in both the VIX options and futures markets year over year. He says VIX is the most liquid volatility market in the world and confirms volatility as an asset class. He states the growth in VIX has outpaced his early expectations.
Bowler also mentions that the volatility market of today is back to 2007 levels. He also notes that the spread between 12 month and 1 month volatility has recently hit an all-time high. He also noted that the spread between 6 month skew and Asian skew is at all-time highs while Eurostoxx skew is at an all-time low.
Finally he noted that post 2008 crisis implied volatility to realized volatility spreads have been running at a much higher level than before the 2008 crisis. This demonstrates increased demand for S&P hedges.
VIX Futures term structure has reached record levels of steepness post 2008 in part due to the growing market for tradable volatility products. Also, VIX Options have remained consistently rich through time as a result of excess demand for options on volatility.
Bowler demonstrated some more traditional methods of taking advantage of Alpha opportunities, but did sum things up by saying that the liquidity of the VIX markets has resulted in new methods of Alpha creation.
Michael Wexler started out noting that the majority (99%) of option users use options for directional moves either bullish or bearish. His term for them is non-economic volatility traders – they are more focused on the price change outcome from the underlying market. They do however through buying and selling options influence the implied volatility of options.
He mentions that options are historically overpriced. There are times they are not, but the majority of the time they are overpriced. He notes that buy write and option selling strategies take advantage of this persistent over pricing of options. He equates this ability to profit from selling options to insurance companies selling insurance policies above their realized volatility.
He notes the purchase of insurance results in a peace of mind that they would not have without insurance. This exists in financial options as well where purchasers of options will slightly overpay in order to get peace of mind.
Finally, he talks about how being short volatility can result in a trade not working out too well. His firm attempts to diversity their exposure by diversifying their short volatility exposure. Although diversification of short volatility exposure cushions the effects of market events that result in volatility spikes, there are still times when short volatility portfolios will suffer losses. Typically it is a multi-asset and multi-geographic event to negatively impact the portfolio. A big mistake that volatility sellers make is not diversifying their exposure.