How to profit from interest rate volatility

Key Points

• Interest rate option markets exhibit pricing inefficiencies just as global bond markets do, which represents an opportunity for investors with the right expertise to generate uncorrelated returns.
• ‘Long volatility’ (i.e. option buying) strategies offer a compelling way to profit from interest rate volatility, without having to rely on predicting the direction of rate movements.
• These strategies can be implemented in a favourable asymmetric way (i.e. small downside vs. disproportionally large upside) using interest rate options.
• The maximum downside risk is limited to the modest cost of the options and is therefore known with certainty up-front.
• These strategies generate profits from large interest rate moves, irrespective of their direction, which is what also makes them useful for portfolio protection in adverse market environments.
• Long volatility strategies are effective (yet underutilised) tools for portfolios that prioritise low volatility, defensive risk diversification and outperformance in adverse market environments.
• They are particularly useful for protection against downside risk in credit because the payoff profiles of credit investments are similar to selling options.
• At current levels of depressed volatility pricing it has never been cheaper to implement these types strategies for portfolio protection, as well as alpha generation.

 Summary

One way to profit from interest rate volatility is to get directional calls right, ahead of a large move in rates.

Sadly, we have yet to come across anyone who has been able to consistently get these directional calls right. Even the bond kings and macro gods who pride themselves on being able to foresee market swings have struggled. (The bears come for the bond king, Masters of the universe struggle to read market)

Getting market directional calls consistently right is just really hard, which is why our preference is to position for market swings using non-directional interest rate option strategies.

We’ve previously discussed how the large and liquid universe of global interest rate options offers a great set of tools from which volatility strategies can be constructed to provide reliable downside protection for investment portfolios. (Refer – Volatility strategies are reliable risk diversifiers)

At the same time, these markets are subject to the same pricing inefficiencies and inconsistencies that are pervasive across global bond markets, so they also offer uncorrelated alpha opportunities, with downside risk that is modest and known with certainty.

We exploit these opportunities in a risk-controlled way using ‘long volatility’ strategies (i.e. option buying strategies), which can profit when markets start moving in any direction, while the maximum downside is limited to the modest cost of the options and is therefore known with certainty up-front.

Just such an opportunity presented itself last quarter, culminating in a sharp repricing of interest rate option markets in March, yielding profits for long volatility strategies.

(For the full article please download the PDF document titled – “How to Profit From Interest Rate Volatility”)

Background Information

Option selling strategies – aka ‘short volatility’ strategies – generate returns by earning a premium (i.e. up-front payment) in return for selling options. The option seller’s profit potential is limited to the premium earned but the loss can be unlimited.

By contrast, given the defensive nature of our strategies it suits us very well to be on the other side of these short volatility strategies and it’s never been cheaper for option buyers like us to be ‘long volatility’.

Long volatility strategies have a positively asymmetric payoff profile (i.e. downside limited to the cost of buying options vs. potentially unlimited upside), and can generate outsized profits when there are large movements in interest rates, as there have been this quarter.

Option sellers are effectively betting against tail risks i.e. infrequent but high impact market movements, which by definition don’t happen often. So their return profile tends to show periods of stable positive returns (generated by earning option premiums), punctuated by short, sharp losses when large market movements impose losses.

An example of such a loss occurred in February 2018, when short volatility strategies were badly hurt by the sudden equity market sell-off and many ETF’s and other investment structures linked to the VIX index collapsed. (Refer – Investors burned as bets on low market volatility implode)

Such strategies use to be the domain of a few specialists and only represented a niche allocation for investment portfolios. However, as years of ultra-low interest rates forced return chasing investors to take more risk, these strategies have grown exponentially, even into products targeted at retail investors.

A 2017 paper by Bhansali and Harris estimates the total AuM of short volatility selling strategies is about $1.5 trillion. (Refer – Everybody’s doing it)

Some believe the Feb-2018 VIX implosion was just a small taste of the volatility storm that could be unleashed if an unexpected market movement forces these strategies to unwind.  Even back in 2013, the Dallas Federal Reserve stated the following;

“Although selling volatility may seem like a simple, profitable idea, it carries risks that could potentially spread throughout the financial system. Given the growing popularity of this strategy, further investigation may be warranted to examine systemic issues arising from volatility selling.”

While short volatility strategies are a legitimate source of return, the risk vs. return characteristics can vary greatly over time as market conditions change, and as with any investment, it can be pushed too far when lots of capital floods into the sector chasing returns.

This is what’s happening now as the pricing of volatility in option markets has collapsed to very low levels, meaning option sellers are no longer getting as much compensation for the risks they’re exposed to. The flip side being it’s never been cheaper to run ‘long volatility’ strategies like ours.

While we can’t know whether the growth of short volatility strategies will end up causing a crisis, we do sleep a lot better knowing that our portfolios are very well positioned if that was to happen.

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The full article covers some of the unavoidable option jargon, provides examples of strategies and explains how they can complement a broader investment portfolio.

It can be accessed via the PDF document titled – “How to Profit From Interest Rate Volatility”