Home Business More Volatility In 2018, But Not Enough To Damage Income Producing Risk...

More Volatility In 2018, But Not Enough To Damage Income Producing Risk Reversals, Says BAML

2017 was a great year for bullish risk-reversals, Bank of America Merrill Lynch’s Equity Derivatives team observes. But with 2018 looking into the eye of several potential storms, will low volatility continue to dominate?

Get The Full Warren Buffett Series in PDF

Get the entire 10-part series on Warren Buffett in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues

Risk reversals won't get hurt in 2018 as volatility will have a lid

Risk reversals, a synthetic option strategy of both buying and selling out-of-the money puts and calls simultaneously, was a primary BAML strategy recommended last December. The goal of the bullish risk-reversals was to uses the investments “as a means of generating income (while maintaining market beta) from historically elevated levels of skew.”

Had investors used this strategy, BAML points out, it “would have generated a 1 (year) Sharpe ratio of 1.07 vs. 0.94 in the case of ESTX50 Total Return.”

But that wasn’t just a strategy for 2017.

“2018 will likely remain conducive for income-generating risk-reversals,” the report noted, pointing to many consistent performance drivers in 2017 that “should remain relevant.”

Sell those income-generating spreads in 2018, BAML recommends. “If markets behave as expected, risk-reversal strategies could end up yielding more than equities outright.”

This strategy of collecting a premium has worked in the past:

Risk-reversals tend to outperform equities in most environments. Purely from a statistical standpoint S&P500 risk-reversals would have outperformed the S&P Total Return in 11 of the last 17 years, from a risk-adjusted perspective. Even on a rolling (as opposed to end-of-year) basis, S&P500 risk-reversals would have generated greater 1y Sharpe ratios 62% of the time since Jan-01. For the ESTX50 and NKY, the frequency of outperformance is 60% and 71%, respectively (since Jan-08).

Risk- reversal: Central bank support of the market is expected to peak in the first quarter of 2018

Don’t mistake BAML’s positioning and their propensity for “income generating” assets. They “expect vol to rise” in 2018. But the increased volatility is not expected to rise above its long term average as “global (central banks) curtail their support of markets and G4 balance sheets likely peak in 1Q18,” the report stated. “Historical evidence across major global indices suggests that below-median vol is particularly beneficial for risk-reversal outperformance vs. the underlying market (on a Sharpe ratio basis).”

Looking into Europe in more depth, BAML’s Jason Galazidis and his team eye the Italian election, which is coming up March 4, and recommend “shallow hedges” on specific EU stock sectors.  The current center-left coalition led by Matteo Renzi is battling center-right coalition led by Silvio Berlusconi, with concerns that the populist party in the region might gain strength. If this happens, banks, autos and basic resources might find difficulty.

The preferred spreads are found shorting the banks, particularly the Euro Stoxx Banks index (SX7E), as well as similar indexes in autos (SXAP) and basic resources (SXPP).

“These indices offer the cheapest put spreads relative to history,” the report noted. “The 3m max drawdowns of these indices around the three latest political catalysts (Apr17 French election, Dec16 Italian referendum & Jun16 EU referendum) were close to the current max payouts of 3m 50d-25d put spreads, which is not the case for most other EU indices.”

Heading into the election, the volatility premium could significantly rise, with some hedges already on the rise in anticipation of the event.

In Asia, BAML strategists don’t think the “lcarus melt-up” is not yet complete. The market that is currently flying too near the sun made of feathers and wax still has time on the clock, BAML surmises.

Even as SPX vol continues to reach new record lows, HSCEI vol is trading higher, in its 30th percentile over a 4-year history. Also, Korean auto-callable issuers’ vega outstanding has plunged since the HSCEI broke a 2.5yr high and most legacy HSCEI-linked products issued in 2015 have likely knocked-out. We think investors should take advantage of rich volatility to own HSCEI Mar-18 1x1.5 call ratios in case of a further rally. The trade has a 6.2x payoff with a breakeven level near ‘15 highs.

Previous articleRobot Cache To Use Blockchain For Online Video Game Sales
Next articleNet Neutrality Could Be Restored Soon
Mark Melin is an alternative investment practitioner whose specialty is recognizing a trading program’s strategy and mapping it to a market environment and performance driver. He provides analysis of managed futures investment performance and commentary regarding related managed futures market environment. A portfolio and industry consultant, he was an adjunct instructor in managed futures at Northwestern University / Chicago and has written or edited three books, including High Performance Managed Futures (Wiley 2010) and The Chicago Board of Trade’s Handbook of Futures and Options (McGraw-Hill 2008). Mark was director of the managed futures division at Alaron Trading until they were acquired by Peregrine Financial Group in 2009, where he was a registered associated person (National Futures Association NFA ID#: 0348336). Mark has also worked as a Commodity Trading Advisor himself, trading a short volatility options portfolio across the yield curve, and was an independent consultant to various broker dealers and futures exchanges, including OneChicago, the single stock futures exchange, and the Chicago Board of Trade. He is also Editor, Opalesque Futures Intelligence and Editor, Opalesque Futures Strategies. - Contact: Mmelin(at)valuewalk.com


The Life and Career of Charlie Munger

You can learn from Charlie Munger firsthand via this incredible ebook and over a dozen other famous investor studies by signing up below:Charlie is more than just Warren Buffett’s friend and Berkshire Hathaway’s Vice Chairman – Buffett has actually credited him with redefining how he looks at investing. Now you can learn from Charlie firsthand via this incredible ebook and over a dozen other famous investor studies by signing up below:

  • Learn from the best and forever change your investing perspective
  • One incredible tidbit of knowledge after another in the page-turning masterpiece of a book
  • Discover the secrets to Charlie’s success and how to apply it to your investing

Never Miss A Story!

Subscribe to ValueWalk Newsletter. We respect your privacy.


    We won’t send you spam. Unsubscribe at any time.
    Exit mobile version