Asset managers look to index derivatives as volatility spikes
Asset managers are increasingly looking to derivative strategies to enhance risk profiles and protect against surprise market moves. While Australian managers have traditionally proven comparatively conservative in their use of derivatives – the types of complex structured products employed across Europe and the US in the years preceding the global financial crisis have never taken much hold here – interest in index derivatives is on the rise.
According to the Australian Securities Exchange (ASX), in September 2019, equity derivatives volumes were up 5% on the previous corresponding period (PCP). Futures volume was up 10% and average daily options volume was up 3.4%.
That, the ASX said, is driven by funds under management increasing buy-side open interest, coupled with new proprietary trading activity taking short term market views in futures. Options market volumes are driven largely by market volatility, so when index volatility is high, managers tend to use index options strategies. Conversely, when volatility is lower or at normal levels, they switch to using single stock options.
While there is no doubt that derivative strategies can be complex, they also provide valuable hedging capabilities and transaction cost efficiencies. Kieren Callaghan, former CIO of Denning Pryce, is one buyside manager who has regularly used derivatives-based strategies to enhance risk profiles and, in particular, to deliver performance in the event of surprise.
Speaking at an ASX breakfast briefing in Sydney this week, Callaghan outlined a number of strategies using index options that have worked well in turbulent times.
A put option entitles a buyer to sell an underlying at an agreed strike price for a specific period of time, a strategy that works well in the event that markets fall. Conversely, a call option gives the buyer the right to purchase the underlying at the strike price, which is advantageous if the price of the underlying increases. Using a combination of the two, as Callaghan did during the Brexit and Trump election campaigns, can allow you to protect your portfolio during a downturn while also delivering performance in the event of surprise.
“Around March 2016, we started selling shorter dated calls to fund buying longer dated puts in the XJO index in a ratio of one to two, which was a low-cost strategy that delivered us the appropriate exposure. On the day of Brexit, [on June 23, 2016], we monetised some of the gains by selling put options and covering the calls, and rolled the rest over into November, enabling us to build our position for the US presidential election, the result of which was almost identical,” Callaghan told the audience.
The tabling of the Hayne Royal Commission proved another clear example of the benefits that options strategies can bring to a portfolio. However, with implied volatility at yearly highs, Callaghan decided to sell longer dated upside calls and use some of these funds to buy shorter dated (weekly) calls. This structure enabled the fund to sell the volatility component of the option (vega, which measures the sensitivity of the price of an option relative to a change in the anticipated volatility of the underlying security) whilst being protected against an aggressive short term upside rally.
“What was the outcome? The report was tabled, the market perceived it very bullishly and we had savage price spikes in the ensuing days. We were able to monetise the gains in the weekly calls that we bought, and as volatility normalised we were able to crystallise more performance from the improvements in the vega structure that we had sold previously,” Callaghan said.
To Callaghan, the key advantage to actively managing options is in the flexibility it allows to deliver the performance required. “You do need to have absolute clarity about the objectives of your risk profile, [but] we believe that a fully flexible portfolio of equities and options can deliver the investor to their targeted objective on the investment horizon. You use that clarity to determine the structure that is aligned with that objective, and then use the tools that are at your disposal to derive the feedback in the form of performance attribution & contribution. Feedback is the gift that enables you to hone, to refine and to redefine your investment performance,” he said.
For those managers that don’t have a mandate to trade options, it can still be valuable to have a look at options screens, because it can provide valuable information about the market’s perception of a particular underlying.
Callaghan said this was the case last year, when reporting volatility for Macquarie appeared more subdued than in the past, the skew on calls increased and people were happy to sell puts. “That told me that the market wasn’t that concerned about downside risk with respect to Macquarie, so I rolled out of my options position and just took a straight delta one stock position. We subsequently saw the stock rally quite nicely, so that was a good performing decision for the fund,” Callaghan said.
“If you can understand the concept of skew, examination of option pricing can give you concrete data around the markets perception of the risks to a stocks price, either up or down. This can often be the missing piece in the puzzle surrounding their earnings and reporting,” he said, adding that by doing so, fund managers can use exchange traded options to actually deliver alpha.
“In fact denying yourself the flexibility of transition between passive and active instruments is leaving that performance on the table for someone else,” Callaghan said.