Key takeaways 

 

•         A sign of how stressed markets are despite pushing new highs, volatility is aggressively rising with equities

•         Harvest this fear to play for a potential post-election vol collapse, a continuation of the equity bubble or RV

•         Optimised EU volswap dispersion is an attractive way to stay long vol (with currently positive carry) in the face of high VRP

 

 

INTERACTIVE ANALYTICS 

   

Vol rising to historically stressed levels despite equities rising to new highs

Vol markets are displaying increasing risk aversion to rising equity markets, as price momentum meets market makers short upside gamma, election risks loom large, investors hedge US equities at all-time highs, and vol supply has collapsed post the Covid shock. The spot up/vol up dynamic we have been highlighting for weeks has accelerated (e.g. VIX +4.77pts, S&P +4.28% in the last 12 trading days), including repeated outsized intraday gains in vol as markets rise. The dynamic has been particularly strong in US Tech, with Nasdaq vol hitting 10y highs vs S&P vol even as NDX continues to outpace the broad market. But the phenomenon is not limited to the US -SX5E spot-vol correlation has turned positive even for short-dated vols. The risk aversion is also evident in the extreme S&P implied-to-realized vol spread, with VIX 17pts above trailing 21-day realized vol, only surpassed 40 out of 7,707 trading days since 1990, mostly after major shocks.

 

The implied-to-realized vol spread is most elevated in US indices, with the upcoming election helping inflate the implied vol premium. While we are still concerned about a contested election outcome and recommend hedging this tail risk, a clean election outcome could free the VIX to converge sharply lower towards realized vol, particularly if it helps coax currently dormant vol supply back into the market. To that end, we like selling Oct VIX puts (forced to mechanically price election uncertainty but expiring before the vote) to cheapen the cost of Nov VIX puts (for a post-election normalization of the vol risk premium) or Dec SPX calls (for a post-election melt-up). Separately, we suggest taking advantage of the record-high NDX-SPX vol spread through either (i) put vs put to hedge into year-end, or (ii) SPX over NDX outperf. calls to add cheap cyclical exposure to overweight Tech portfolios. Finally, harvest the S&P vol risk premium by selling delta-hedged SPX Oct straddles, hedged with straddles on NKY, the one global index with below-median VRP.

 

Pay dues at the FX election rollercoaster with relatively elevated rates vol

 

While rates vol is pricing a juicy election premium, the zero lower bound, coupled with continued macro challenges in the near-term, makes extreme moves in rates unlikely in either direction in the short term. On the other hand, since 2000, in all except one episode, FX vol has increased around elections. With the TLT (+20yr Treas.) vs. FXE (EUR) near-dated implied vol ratio near record highs, sell $1.0 vs. buy $2.0 notional of the TLT/FXE Dec20 30d straddle for zero cost. 

 

Long vol bias with positive carry via optimised EU volswap dispersion

 

Currently high levels of the volatility risk premium make outright long volatility positions expensive. Vega-neutral volatility dispersion (long stock volswaps, short index volswap) can offer a more attractive alternative for a long vol bias by reducing the cost of volatility carry. We construct an optimised basket of names from ESTX50 constituents where we find volatility dispersion is attractive versus current implieds even over the (quieter) past 3m. Should we see a resurgence of COVID or other risks materialising in the coming months we expect strong volatility dispersion from this basket like in Q1-20.