This article first appeared in EQDerivatives' subscription Commentary & News service.
Strategists at JPMorgan say a ‘three regime approach’ is the best way to view the market environment right now as the EURO STOXX 50®Volatility Index and the CBOE Volatility Index are trading in the middle-to-low range of the volatility regime, presenting opportunities in both the VIX and the VSTOXX®.
For VIX, the three regimes of volatility consist of low [below 20], medium [between 15-21] and high [above 21], according to Peng Cheng, strategist at JPMorgan in New York. This is appropriate right now as the VIX and VSTOXX® are currently trading around 18. “We think that the VIX is likely to stay in this range for some time to come,” he said. This is because volatility is persistent and has a high tendency to stay in the current range, according to Cheng.
In contrast, the vol-of-vol market is tightening in on a very high level. If you’re looking at the VVIX for example it’s extremely high, he added. Cheng suggests that selling strangles on VIX makes a lot of sense right now, specifically, 15-21 April maturity strangles on the VIX to play the volatility regime persistency in the near term.
To identify the regimes JPM employ a three-state Hidden Markov Model which utilizes the VIX time series data and is therefore purely technical. “We assume the drivers of regime change are based on exogenous fundamental data,” Cheng said. “The model tells us what regime we are likely to be in, but does not predict whether a regime change will happen. For instance, in our model, the amount of time VIX has spent in one regime does not predict the next day’s regime change probability,” he said.
The classification applied to VIX strategies works just as well with VSTOXX®, similarly, when VSTOXX® is high, long VIX strategies perform well and when VSTOXX® is in the medium or low-vol regime then short VIX strategies perform well, Cheng said.
Generally speaking the VSTOXX® spends most of its time in the medium vol regime, according to Cheng. Looking at history he notes that the index spends 50% of its time in medium vol regime, around 30% in low vol, and 20% in high vol. Right now, the VSTOXX® is trading at around 18, and when the VSTOXX® below 20 you want to be short VSTOXX® Futures.
“This is relevant right now because if you look at the performance of short VSTOXX® Future strategies, like short VIX strategies, they did not get wiped out [last month] because of the jump in the VIX,” he said. The drawdown in February was a lot lower than the VIX, so in comparison it is more favourable to be short the VSTOXX® Futures than the VIX futures. “We have always been advocating shorting VSTOXX® Futures as an attractive alternative tool for diversification on top your short VIX strategies,” he said. This a very good example to show that there is value in having short VSTOXX® strategies besides the short VIX strategies, he said.
At BNP Paribas, strategists believe the recent trend of higher VIX relative to VSTOXX® is likely to be an anomaly rather than the start of a new trend. “An interesting trade we have been suggesting to our clients is to sell May18 puts on VSTOXX®/VIX spread in order to receive carry,” said Ankit Gheedia, a macro equity strategist at BNPP in London. He expects Eurozone equities to remain more volatile than U.S. equities throughout 2018. “In the short-term we are awaiting [the] outcome from Italian and German politics, which has the potential to drive markets. In the medium-term we see three main reasons for realized volatility to remain higher in Europe. Firstly, earnings risks coming from a stronger Euro could impact large cap equities during the upcoming earnings seasons. Secondly, we see much more uncertainty regarding [European Central Bank] policy adjustment this year than the Fed’s. Finally, structurally [the] SX5E is overweight cyclicals vs. SPX,” he said.
|Georgia Reynolds is a reporter at EMEA at EQDerivatives, based in London.|
A recent graduate from City University London, Georgia has been studying and producing print and multimedia journalism for five years.
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