By Theo Casey, a columnist at Futures & Options World, blogging live from FOW’s European Equity Options conference in Amsterdam.
Presenting the best trading idea of the conference…
The Bernanke put, and Greenspan put before it, is the notion that when the economy veers off edge of a cliff the Fed will act as the market’s insurance policy. It’s a concept that manifests itself in asset swaps with banks, interest rate cuts and quantitative easing.
Alas, as SocGen, Goldman Sachs and Morgan Stanley tell it, that easing will soon become tightening. Short and to the point from SocGen:
“[We expect] delivery on the $600bn of QE2, but no more.”
So with the stabilisers off, investors will have to come up with some insurance policies of their own. Why? Because “tail events” happen more often than some might think. A presentation by SocGen shows that equity markets have encountered twenty-one drawdowns of more than 20% over the past thirty years.
Valid criticisms aside, it is the VIX that offers the most explosive move upwards during such crises. Take this matrix of results from SG:
One adapted insurance policy, or “tail event hedge” is the 1×2.
How does it work? OK, here we go…
Step one: Identify the “sweet spot” on the curve*
Step two: Sell an out of the money call option on the VIX.
Step three: With the income generated from selling the aforementioned call, buy two more calls – further out of the money, hence cheaper.
Step four: Rinse and repeat – Once all three options are no longer in the “sweet spot” sell them all and buy those options that are.
*The “sweet spot” is the region – between twelve weeks and eight weeks to expiry – where roll yield does not eat into your returns and that you can still see an explosive upside to your investment.
How should you think about 1×2?
It’s a bear trade with massive firepower: If “short S&P” is a leaky water pistol then “long VIX” is two sticks of dynamite. “Long 1×2” is those two sticks of dynamite going off in a dynamite factory.
Boom.
In times of real market distress the 1×2 rises higher than does the VIX.
Additionally, in placid markets, it falls less than the VIX.
Oh, and it’s cheaper.
In fact, it is only in times of moderately rising volatility will investors be punished for selling an out of the money position that is NOT compensated for by a subsequent rise up in a further out of the money position.
Quite understandably it’s becoming very popular.
Nearly everyone in the volatility space here in Amsterdam is talking it up. “I put this trade on for around ten asset manager clients”, says one American volatility trader I spoke with.
And some of those people are developing indices based on the premise.
What does this mean for the VIX?
It’s all good news for the men from Chicago. Sell-side institutions, academics, prop traders and columnist-cum-bloggers are tripping over each other to license indices based on CBOE’s special sauce.
My prediction? You’re going to start hearing a lot more about the 1×2 in 2011.