Hedging equity positions should be cheaper next year as markets become less volatile, although macroeconomic aftershocks will underpin demand for protection. While market volatility this year - and therefore hedging costs - have lessened from a pre-Greek bailout peak in May, they remain historically high.
-- Equity gains to prevent wholesale stampede
-- Implied volatility key to price
-- Put spreads in favour on cost basis
Dramatic market swings and the cost to investors of insuring against downside risk increased sharply after the collapse of Lehman Brothers in 2008.
Such market turbulence appears to diminishing but spikes are nevertheless expected through 2011. This will drive investor demand for protection from short, sharp falls in equity prices, with market players picking put spreads as a favoured play.
Under a put spread strategy, an investor buys put options at a specific strike price while also selling the same number of puts at a lower strike price. These are useful for fund managers and other investors who think the market will only dip a bit.
Costlier put options give holders the right to sell out of their position at a set price within a specified time. This protects those with a more bearish or conservative investment approach from a downward slide in the underlying asset, while the cheaper put-spreads see that protection taper off.
For a marked shift to downside protection in the form of buying puts over put-spreads to occur, the E-STOXX 50, Europe's most liquid index for options trading, would probably have to fall sharply into the 2,500s, around the May lows, according to Pete Clarke, Citi's European equity derivatives strategy head.
"Down 10-15 percent from current levels (around 2,860), is where a lot of the existing put-spread protection would start to run out," he said. "If we were to move down to around those levels then that's where I'd expect to see some real panic coming back into the market, resulting in a true scramble for protection."
Clarke sees sustained panic buying of downside protection as unlikely as equity markets are expected to rise in 2011, although short-term spikes on the back of macroeconomic shocks are more than likely.
"There will doubtless be plenty of justification for further 'mini panics' throughout 2011, with ongoing concerns over sovereign debt and global growth, but we would regard these sell-offs as buying opportunities, and we don't expect to see anything on the scale of 2008," he said.
A volatility surge in May, when the eurozone debt crisis began, was still only half as bad as that experienced during the fall of Lehman Brothers, which presaged the financial crisis.
Three-month at-the-money put premiums on the E-STOXX 50 rose to near 12 percent at the height of the crisis, with a 100 percent-to-85 percent put-spread premium at near 6 percent. Currently they are at 4.6 percent and 3.6 percent, respectively. A recent Reuters poll showed steady gains for all major indexes in 2011, driven by emerging market strength, although eurozone debt concerns would continue to weigh.
"There will be less volatility, at least at the start of next year, and that should continue unless the eurozone debt problems start to reach Spain and France," Giles Watts, head of equities at City Index, said.
However there will still be significant periods of volatility, though they are likely to be much more short-lived than those seen over the last two years.
Those limited sell-offs would likely result in "pops in volatility and elevated volumes of protection buying", although the market would likely remain focused on put-spread structures "unless you were to see a true capitulation", he added. The volatility index on the E-STOXX 50, is currently at 18.4, down over 23 percent this year and off a May 21 high of 54.59.
A 10-year backtest on the E-STOXX 50 by Deutsche Bank showed the put-spread collar - selling an out-of-the-money call to offset the cost of the put-spread - to offer the best risk return profile among the common vanilla option hedging strategies in their sample, though it limits upside potential.
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