S&P relative-value vol trades backfire

Losses estimated at close to $500 million as US index volatility spikes

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Investors lost out as vol surged on the S&P 500 while climbing less for single stocks and other indexes
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Investors are said to have lost almost $500 million on popular relative-value trades over the past week, as volatility surged on the S&P 500 while climbing less for single stocks and other indexes, against which the volatility of the US index is typically shorted.

Generally, the US index has been more stable than other parts of the equity market, tempting many firms into the trades over recent years, but that behaviour has been turned on its head during the mayhem of the past week, generating mark-to-market losses.

“The trade everyone has been doing for the past five years is long volatility on Euro Stoxx 50, or one of the Asian indexes, and against that the whole world sold S&P volatility,” says a strategist at one European bank. “This week was terrible, as the long leg didn’t move that much compared to the spike in S&P volatility.”

A relative-value volatility trader at one large hedge fund says the past week has been “a very bad time”.

Traders at three equity derivatives dealers claim some investors are continuing to put on new trades, seeing the moves of the past week as an opportunity.

The trades that have been worst-hit include corridor variance – in which investors are typically long Nikkei 225 or Euro Stoxx 50 volatility and short the volatility of the S&P 500, as long as spot on the first index remains within a certain range – and dispersion trades, in which investors short the volatility of the US index against the individual stocks.

An investor that executed the corridor variance trade on February 2, shorting the US index and going long the Nikkei, would have entered at a difference of 3.67 points between the two. By close of trading on February 8, the spread had fallen to 2.04 points.

A trading desk head at one dealer estimates the market as a whole has a corridor variance position worth somewhere between $200 million and $250 million of vega – implying a mark-to-market loss of $300 million to $375 million on the roughly 1.5-point change in the spread. 

The geometric dispersion trade lost less than standard dispersion trades, but that’s pretty broad brush, and it really depends on the specifics of the portfolio
Volatility trader at a large hedge fund

For an S&P dispersion trade, in which the investor shorted index volatility against its 50 biggest constituents, the spread between the two was being quoted at 9.83 points on February 1, falling to 8.82 points on February 7. The market’s aggregate position in these trades is estimated by the same desk head to be worth roughly $75 million vega, meaning the one-point drop over the past week would have generated a $75 million loss.

The corresponding European dispersion trade has seen the spread decline by around half a point over the same period, generating a loss of about €25 million on an estimated aggregate vega position of €50 million.

In all, the maximum mark-to-market move adds up to roughly $480 million.

Three market participants say those figures are plausible. A fourth says the corridor variance vega position seems too high.

So-called ‘geometric’ dispersion trades, in which an investor is long the volatility of a basket of stocks, and short volatility on the geometric mean of the same names – instead of their index – are said to have performed better than the classical dispersion product.

“The geometric dispersion trade lost less than standard dispersion trades, but that’s pretty broad brush, and it really depends on the specifics of the portfolio,” says the hedge fund trader.

Hedging vega exposure

The corridor variance swap, first traded in Asia as a way to recycle the risks dealers accumulate from issuing popular structured products, known as autocallables, gives an investor exposure to the realised variance on an index, but only while the price of an underlying moves within the boundaries of a set range. This range usually reflects the barriers within the autocallables, allowing dealers to hedge their vega exposure.

It is a relatively sophisticated product, which is traded by around 25–30 hedge funds, asset managers and pension funds, according to the trading desk head. The trades tend to have around a two- to three-year maturity on average.

While some investors such as PKA have said variance swaps have been less attractive to enter in 2017, the head of equity derivatives at one US dealer says hedge funds were keen buyers of S&P/Nikkei swaps in particular.

He says the bank saw a handful of unwinds of S&P/Nikkei products this week, but as many investors don’t expect any fundamental change in the volatility environment during the lifetime of the product, they are happy to wear the mark-to-market losses for now. In some cases, investors are said to have been adding to their positions at the current low spreads, expecting them to widen.

Dispersion trades were one of the big trades of 2017, as the election of US president Donald Trump triggered sector rotations in equities that saw investors move cash into areas such as financials, industrials and defence stocks.

This meant the volatility profile of individual shares began to diverge from the index average, which could be captured by creating dispersion products that went short S&P index volatility and long single stock basket volatility. Like corridor variance swaps, however, the spike in S&P volatility and relatively muted reaction of single stock volatility has led to mark-to-market losses.

Investors were also caught out when the surge in the Vix index – which tracks expectations of US market volatility – outpaced the rise of its European counterpart, VStoxx. Shorting US equity volatility against European measures has been an effective hedge through previous bouts of market turbulence, but this time investors failed to gain enough on their long VStoxx positions to offset huge losses on Vix shorts.

The European volatility benchmark, which tracks the price of Euro Stoxx 50 options, closed at 30.18 on February 6 – a near 90% jump from the 16.14 close on February 1. The Vix jumped by more than 170% by Monday’s close, leaving the trade underwater.

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