In mid-August, at the height of the North Korea geopolitical turbulence, and amid uncertainty about the Fed balance sheet unwind, fears of a government shutdown and the US debt ceiling, as well as the fate of Trump tax reform and Obamacare repeal, when the VIX soared following a series of missile launches by Kim Jong Un only to crash right back to near all time lows, we used an analysis from BofA’s derivatives analyst Benjamin Bowler to show “How To Hedge A Near-Term Market Shock: Here Are The Best Trades“
As we said then “if the events from last week demonstrated something, it is that just when there appears to be virtually no risk, is when the likelihood of a historic surge in volatility is greatest, as many experienced first hand last Thursday. Hence the need to hedge. But what? And using which product?” As Bowler explained “the decision about whether it’s rational to hedge is really a matter of looking at the price of tail insurance embedded into option markets and asking if the probabilities they assign are “fair” or not.” As he further wrote, when it comes to predicting what the next “severe tail event” could look like, “we find that not only are some markets like Gold pricing in a very low probability of Korean risk escalation, there are significant differences across assets in terms of what they imply about potential risks.”
He then presented the chart below which shows how historical worst 3M drawdowns since 2006 are priced by 3M 25- delta options across asset classes; hedges that are most underpricing their historical drawdowns are at the top and those most overpricing their tails are at the bottom. What the chart shows is that gold call options imply less than a 1 in 100 chance of a severe tail event over the next month, despite being among the most reactive assets to rising Korean tensions last week. With record low Gold vol slaved to record low real rates vol, this represents a loose anchor which likely won’t hold in any significant geopolitical risk escalation. In contrast to gold, Nikkei is at the other end of the spectrum with options assigning over a 5% chance of a near term tail-event.
In other words, as of mid-August, BofA’s analysis found that Gold was pricing in the smallest probability of a “tail event”. The implication also is that should a “tail event” occur, the return from a gold-based hedge would be the one with the highest return (more details in the full article).
Fast forward almost two months to today, when not only have there been no crashes since mid-August, but complacency has returned to all time highs as the VIX is back within shouting distance of an 8-handle, after a record low September; of note, the VIX closed at 9.51 on Friday, down 0.08 points week-over-week. It was the third consecutive close below 10 and the eighth during September. It has remained in that ballpark since.
And with complacency once again the norm, traders, at least those who are not confident that stocks will keep rising in perpetuity, are again looking to reload hedging trades, and obviously, the cheaper the better.
Which brings us to the latest analysis from BofA’s Benjamin Bowler released overnight, who has again broken down the cheapest way to hedge against a market crash.
What he finds is more of the same, namely gold. As he writes, “gold traded in a wide range between 1,159 and 1,349 in 2017, pulled in multiple directions by the forces that drive it-the main two being US rates and geopolitical risks and to a lesser extent, dollar strength, oil prices and Asian demand.”
More importantly, on the implied vol side, short dated gold vol has been cheap for most of the year and gold calls have repeatedly screened as the cheapest proxy hedge. With the most recent US rates rebound, however, short dated gold implied vol has ticked up, while longer dated implied vol remains subdued. The price of a GLD 6m 95/105 strangle has averaged 3.8% in 2017 (7.4% since 2008) and has recently dropped to an all-time low just below 3%.
But most notably, as the chart below shows, “gold strangles with 6m maturity have never been cheaper in history.
GLD strangle for 3%.“
For institutional investors who find gold a little too “exotic” of a vol hedge, BofA also provides two other cheap market selloff hedging trade recommendations:
- Trade #1: Hedge a coordinated bond/equity sell-off via long HYG Dec17 88 puts for 1.3% or 88/84 put spreads for 0.9% (ref. 88.8)
- Trade #2: Hedge a flight-to-bonds risk-off event via long 0.4x IWM (Russell2000) Dec17 139 put (ref. 148.2) and short 1x HYG 85 put (ref. 88.8) for zero cost
Hedge a coordinated bond/equity sell-off via long HYG Dec17 88 puts for 1.3% or 88/84 put spreads for 0.9% (ref. 88.8): HYG’s sensitivity to both rates (see Chart 12) and equities makes it an ideal candidate to hedge a simultaneous sell-off in the two asset classes à la Taper tantrum in May-13, in light of high valuations, Fed balance sheet reduction and uncertainty over a change in leadership. With short dated vol on HYG on its 10yr floors and put skew rarely trading as expensive (see Chart 13), we consider HYG puts/put spreads attractive to hedge a coordinated bond+equity sell-off.
Hedge a flight-to-bonds risk-off event via long 0.4x IWM Dec17 139 put (ref. 148.2) and short 1x HYG 85 put (ref. 88.8) for zero cost: Small cap equities remain mired in a low vol regime with Russell2000 realizing the least vol in 20-years. This has contributed to compress the IWM-HYG implied vol spread to its lowest level over the past year (see Chart 14). Notably, in a risk-off event where investors flock into perceived safe-haven bonds, any sell-off in HYG is likely to be partly offset due to the diversification benefits stemming from its rates exposure. Hence, in such a scenario we prefer owning IWM puts against HYG puts, a strategy that at current pricing has offered a highly asymmetric risk-reward (see Chart 15).
The bottom line: for those worried that the current blow off top “Icarus rally” will end some time in the next few weeks, as BofA’s Michael Hartnett predicted yesterday, ignore S&P puts (or selling calls), and just buy either outright gold calls, or 6M gold strangles, which as noted above, have never been cheaper. Wary of gold? Then buy HYG puts/put spreads to hedge a coordinated bond+equity sell-off, or alternatively, own IWM puts against HYG puts, “a strategy that at current pricing has offered a highly asymmetric risk-reward.”