A Return To Macro Events

As earnings season winds down, focus will shift away from company specifics onto Fed nuances, tapering timelines and interest rate fears; noise that typically triggers sentiment shifts with an attendant spike in volatility.

Not surprisingly, we are seeing signs that the US economy is not as robust as some might have thought. Mind you, that could be seen as a positive because the Fed is unlikely to cut their bond buying program when the economy is sending mixed signals. Look for more on the tapering debate in the months ahead.

That said, I see nothing on the horizon that is likely to change the tapering timeline. I expect the US Fed to cut back on its bond purchase programs in the early fall, and will have made some definitive cuts by the end of the year. I simply do not believe the Fed wants its new Chairman to become embroiled in this debate as soon as he or she takes office. Better to have the exiting Chairman make the hard decisions and let history bear witness to the success or failure of those actions.

Having said that I have to believe the market has already discounted a tapering timeline, especially in terms of the mortgage market! There will, of course, be the immediate reaction when tapering becomes a reality, but that will likely be short lived. The other concern is what impact tapering might have on interest rates, which I also think will be minimal as rates are expected to remain abnormally low well into 2015.

The real surprise might be if the US economy is doing better than expected. If we see better than expected GDP growth, stronger jobs numbers and mild inflation that could lead to higher stock values on both sides of the border. But more likely the next couple of months will see markets locked in a narrowing trading range with bouts of volatility from an unexpected datapoint.

Since the market is a leading indicator, there was be some fallout in the government bond market to interest rate fears. On the surface, that point of view may seem to fly in the face of our earlier comments where we will not likely see any major change to interest rates until well into 2015. However, there is a difference between Fed action and market anticipation, as we have already seen in how the mortgage market reacted to tapering talk.

The point is, the market will at some point begin pricing in higher interest rates regardless of Fed jawboning. Already, the yield on 10 year US government bonds has moved higher since the end of June, which is why investors have seen declines in their fixed payment securities (i.e. preferred shares and bonds). Most analysts expect 10 year US treasury yields to gravitate upwards, with the next major resistance at 2.5%.

That’s why I have talked in previous blogs about stocks that would be expected to hold up better in a higher interest rate environment. As mentioned previously, bank and insurance companies top the list.

The other strategy you might consider is index straddles. The theory is that markets will become more volatile as traders’ focus shifts away from company specifics onto Fed nuances, tapering timelines and interest rate fears; noise that typically triggers sentiment shifts with an attendant spike in volatility.

A straddle involves the simultaneous purchase of a call and a put on the same underlying index with the same strike price and expiration date. As such, the straddle is a non-directional volatility trade as the call will make money in a rising market while the put profits in a declining market. The overall strategy generates a profit if the underlying index moves up or down by a greater amount than the cost of both the call and the put.

For example, iShares S&P TSX 60 index fund (symbol XIU) closed on Friday at $18.05. The XIU March 18 call was trading at 80 cents while the XIU March 18 put was at 90 cents. The total cost to buy both the call and the put is $1.70 ($1,700 per contract).

The trading range implied by the XIU March 18 straddle is $19.70 the upside and $16.30 on the downside. That trading range is calculated by simply adding the two premiums to the strike price (i.e. upside target) and subtracting the two premiums from the strike price (i.e. downside target). The straddle profits if XIU breeches either end of that trading range at or prior to the January expiration.

But here’s the thing; index straddles also profit if volatility should spike. That’s because volatility is one of the major inputs in the option pricing formula that affects both calls and puts equally. Premium levels for both calls and puts increase when volatility expands and decrease when volatility contracts. And there lies the rationale for entering this trade when volatility is low.

As of Friday the Mx Volatility Index (symbol VIXC) closed at 13.40, which equates to an annual volatility assumption of 13.40%, well below the 18.96% level near the end of June when Fed Chairman Bernanke first hinted at tapering and just prior to the start of the second quarter earnings parade. But does 13.40% constitute low volatility?

To address that question we must first define normal volatility. While there are many interpretations of what is “normal,” I tend to look at the VIXC 50 day moving average because it reflects different market environments and removes much of the day to day noise. If you buy into that concept of “norm,” then volatility is low when the daily VIXC is below the 50 day moving average. The 50 day average at the time of writing was approximately 15.14%.

The objective with the long index straddle is to incorporate volatility as a negatively correlated non-directional asset class within a broadly diversified portfolio. That’s especially relevant now as most analysts don’t believe traditional portfolio diversifiers like bond and gold will offer much protection. And finally, because volatility as an asset class is about six times more volatile than equities, a few long straddles can do the work of many.

So how much of a portfolio should be committed to the straddle hedge? The simple answer rests with the dollar value of the equity assets. For example, if you are holding a $500,000 portfolio with 70% or $350,000 invested in equities, a one to one hedge would require the underlying value the straddles to equal approximately $350,000.

Taking that as our position, one January 18 straddle represents approximately $1,800 of equity value (i.e. $18 strike price multiplied by 100 units per contract = $1,800). Theoretically 167 XIU straddles at a cost of $28,333 would approximate a one to one hedge on the equity assets within the portfolio.

However, as mentioned, volatility is six times more volatile than equities, so theoretically you could reduce the 167 contracts by a factor of 6 which would suggest 28 contracts at a cost of approximately $4,722.