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When volatility is your friend

06 September 2019

4 minute read

By Gerald Moser, Chief Market Strategist

August saw markets sell off, recession fears rise and volatility climb. Is a systematic strategy of selling option premium one way to enhance yields while profiting from bouts of heightened volatility?

Prefer alpha over beta

Since April, we have said that markets were likely to be choppy. However, as we are not expecting any recession in the short term, we believe it makes sense to stay invested as markets should trend slowly higher over the medium term.

We believe it makes sense to stay invested as markets should trend slowly higher this year.

We think that the best investment strategy is to move away from pure market exposure – so-called beta risks – and instead use active management to capture security-specific opportunities both in equities and credit – so-called alpha risks.

Index price returns to be limited

Since April, the MSCI All Country World Index, a global equity benchmark which includes both developed and emerging markets equities, has hardly moved.

While we still believe that global equities should finish the year with a low to mid-single digit price return from April, this would be below the average long-term return from equities. Equally, a global fixed-income benchmark over the same period would have returned less than 5%, and in this case we think that the upside till year-end is even more limited than for equities.

Look for additional yields from volatility

While financial markets have been rocked by geopolitical tensions and increasing fears of a coming recession in recent months, there is one saving grace. Volatility is again looking attractive as a strategy to improve a portfolio total return.

A systematic strategy of selling option premium yields stronger returns when volatility is high. Selling option premium not only helps portfolio performance, it tends to aid portfolio diversification as risk assets typically underperform when volatility is high.

In a way, selling option premium can be seen as a substitute to fixed-income assets. It offers yields, has a different return profile from equities and so offers a different source of alpha that is not linked to index or security-specific selections. It also contributes to diversifying a portfolio. In the current environment, when more than $15tn bonds offer negative returns, enhancing yield by selling option premium is an alternative that we find attractive.

In the current environment, when more than $15tn bonds offer negative returns, enhancing yield by selling option premium is an alternative that we find attractive.

Three golden rules

We would follow three rules to optimise the probability of positive returns in a volatility strategy:

  1. Balance the risk and reward. While the premium is larger if it insures against a small fall in the market, this also translates into higher risks.
  2. Select short-term contracts. With short-term contracts, the risk of a sharp market sell-off is minimised. Although the contract sold ahead of the sell-off is likely to result in a loss, this should be more than recouped by the new contract sold at a higher premium after the market drawdown.
  3. Be systematic. Linked to the example above illustrating the attraction of short-term contracts, we prefer to have a systematic approach as this does not require investors to time the market. Premiums are collected regularly and therefore a loss is usually compensated by the next premium being higher, reflecting a spike in volatility.
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Market Perspectives September 2019

Find out our latest key investment themes. Expectations of more dovish central bank policy could do nothing to prevent a sharp, negative, swing in senitiment in August as recession fears returned to markets. Furthermore, US-China trade tensions seem unlikely to be resolved soon.

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