Hedge funds pile into euro systematic vol selling
Range-bound rates markets in Europe entice hedge funds to sell short-dated straddle positions
As a degree of certainty starts to emerge regarding the path of interest rates in Europe, dealers say hedge funds are increasingly willing to systematically sell rates volatility to take advantage of range-bound markets.
Coming into the year, euro rates markets expected a series of cuts from the European Central Bank, but these only materialised on June 6 when the central bank lowered its policy rate by 25 basis points to 3.75%. Since then, two-year rates have remained between 3.4% and 3.05% and markets are pricing in around two 25bp rate cuts by the end of the year.
In this environment, dealers say an increasing number of hedge funds are looking to systematically sell volatility via swaptions straddle strategies, which aim to profit from a lack of movement in underlying rates without taking a directional view on the market.
“People have been following this trend for a very long time. It’s in the category of selling risk premium, which people tend to like to do in a systematic way,” says a swaptions trader at an international bank.
“It’s increased this year versus the last couple of years because rates are much more range-bound now than they were.”
Typically, the strategy is done through selling at-the-money straddle positions – which sees a fund sell a receiver swaption and a payer swaption with the same strike price, maturity and notional.
The positions that are being sold are typically short-dated expiries, such as one-month options on 10-year interest rate swaps (1m10y). The delta risk – the exposure to movements in underlying rates – are typically re-hedged periodically. The hope is that underlying rates don’t move enough to erode the premium earned from selling the two swaptions positions.
“The idea is that, most of the time, the option price is a bit more than fair value. And that’s especially true in range-bound markets, where you can just be a bit hands-off on hedging the delta and hope you can collect the option premium without having to spend too much of it in hedging,” says the swaptions trader at the international bank.
If there is a big move that sees the underlying rate go beyond the strike of the swaption, that might result in “a painful day or two”, but as the option has a short expiry it will roll off quickly, says the trader.
Another swaptions trader at a European bank says he has seen some firms starting to sell strangles without delta hedging the position at all. A strangle is similar to a straddle position but differs in that it has two strike prices.
Though use of the strategy is visible in Europe and the US, both traders agree it’s proving particularly popular in Europe.
David Cohen, head of euro vanilla options trading at Barclays, suggests the increase in activity around this strategy among hedge funds is roughly 20–30% year-on-year, while the international swaptions trader believes it is higher.
Since the start of the year, 1m10y volatility has traded more cheaply than 6m10y positions. According to Bloomberg data, 6m10y expiries reached 73.6 vols on July 22 compared with 1m10y expiries reaching 60.9 vols.
Some put the difference down to expectations that longer-term volatility is expected to be higher than at shorter dates. The international bank’s swaptions trader says that while the spread can be partly attributed to the range-bound market, it is primarily linked to the systematic sellers selling the one-month expiries.
‘Events, dear boy’
Both swaptions traders attribute the increase to new entrants into the market putting on moderate to small-sized trades quite regularly. They say macro hedge funds tend to put on this position as a side strategy during quieter times, while some banks also wrap up the strategy and make it available as an investible index.
For every three hedge funds there is a non-hedge fund player, such as a pension fund, also putting on the trade, says Barclays’ Cohen.
Demand tends to come from firms that believe there is a chance of paradigm shift or a new risk emerging, such as when French president Emmanuel Macron called for a general election on June 9, says the swaptions trader at the international bank.
“When Macron called the election there was a temporary demand for this stuff. But when these events pass, vol just comes back down again as the sellers come back in. So, it does kind of go in a bit of an ebb and flow,” he says.
“Right now, the demand side is relatively weak versus the supply and you can see that’s why vol has come down to the lows.”
But what’s unclear is for how long the straddle strategy will remain lucrative. Barclays’ Cohen says the strategy should continue to be profitable as long as there is no significant market event in the medium term.
“The thing is that this type of strategy hates ‘events’. If there is an event with a big uncertainty, such as US elections, clients will be more reluctant to sell,” he says.
Editing by Lukas Becker
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