They are known for ETFs used by active traders – particularly the leveraged indexes and the inverse leveraged indexes. Want to make a short-term bet that the market is heading down and want to do it with leverage? You could make that trade hypothesis a reality with their products!
In the last year, ProShares has moved to launch some products that expand past the active trader and to the investor with a longer-term hypothesis. One group of such products are their Interest-Rate Hedged Fixed income products. In particular, in the 2nd half of 2013 launched the IGHG and the HYHG: Investment Grade–Interest Rate Hedged ETF and the High Yield–Interest Rate Hedged ETF, respectively.
Basically, in each case, the fund goes long a diversified basket of the respective Fixed income (either Investment Grade or High Yield). They then use futures to create a short Treasury position of similar duration to the long fixed income portfolio. That is where the ‘Interest Rate Hedged’ position comes in.
As long as Treasury rates go up or down similar to the underlying fixed income interest rate, you will really have no price exposure to changes in interest rates. Instead, this product should really just be capturing the difference in the interest rate spread between the two types of fixed income represented in the ETF. In the case of the IGHG, it is the difference between the Investment Grade yield and Treasury yields. In the case of the HYHG, it is the difference between the High Yield category and the Treasury yields.
The managers at ProShares work behind the scenes to make sure the futures they are using represent a good match as a hedge for the underlying fixed income portfolio. For instance, they need to work to make sure the duration on the portfolio and the hedge are a good match.
If you are worried about a rising interest rate environment, this is a good product to utilize to hedge your price risk on bonds in that kind of environment. Obviously, with the Fed making noise about raising interest rates, these products are well timed.
But these products are not without risk. In particular, the risk of a credit event – or better put, a credit crisis like the one we experienced in 2008 and 2009. When the credit markets get squirrelly, fixed income investors flee products like High Yield and run to Treasuries. This will drive the price of Treasuries up and the price on High Yield and Investment Grade down. In this product, you are short Treasuries and long Hi Yield / Investment Grade. So, this event is the worst possible outcome. Not only will the fund lose value – but it will lose value in a leveraged way since you are dollar for dollar long Corporate Fixed Income and short Treasuries.
So, this product can be a nice product in your portfolio to capture interest spread with little to no interest rate risk – just be sure you understand the risk in a poorly performing credit market.
These products made us start to think: the three most followed Interest Rates in the market are Treasuries, Investment Grade Corporates, and High Yield Corporate (aka Junk bonds). Proshares has built two products that capture the spread between these 3 different interest rate categories. But what about the 3rd spread: High Yield Junk Bonds to Investment Grade Corporates.
ProShares has not released that product yet – and I don’t even know if they are going to. But that got me thinking, could we use derivatives to capture that spread ourselves on some of the large and very liquid ETFs that have options that cover these categories. I decided we should find out.
And that is Part 2 of this article – which we will publish tomorrow!
After two years of relative calm, volatility has once again returned to the forefront of market discussions. You hear about how the VIX has spiked to above 20 for the first time since the government crisis in October. You hear the commentators talk about large institutions putting on insurance through puts. But what exactly does higher volatility mean to options pricing?
Back in mid January (1/12/14) we saw the VIX at 12.14. Today (2/3/14) around 2 PM eastern time the VIX spiked to 20.56. Yes you’ve heard people talk about how higher volatility means options prices become more expensive. But just how expensive?
We took a look at some sample options, both puts and calls from these two dates. The 5 delta strikes were used which would have about a 95% probability of expiring worthless. Where multiple strikes shared a 5 delta, we picked the ones furthest from the money. Both month’s options have 39 days until expiration.
Both the calls and puts each gained. In fact the puts are 45.8% more expensive. The calls $31.24%. Another interesting observation is the distance from the SPX index to the 5 delta strikes. In January, 92 points between the 1930 call strike and the underlying vs. 125 points for February. 188 points separated the puts in January vs. 270 points currently. To put another way, you are getting paid more as an option seller despite the fact that your options are further away from the money.
While it’s not possible to get tomorrow’s stock market prices today, you can look to the options market to understand how far a stock may move up or down using an underlying’s Implied Volatility or I/V. In fact last night the options market is predicting a about a 1% move + or - in the S&P 500 Index. Wanna know how we did that?
With us in the midst of earnings season we’ve see what a big driver of price missing or crushing estimates can be. Other things that drive quick price moves are product announcements, FDA announcements, CEO’s being sentenced (more on that later). When big news is on the horizon, traders anticipate price will break even if they are not sure what direction.
Indexes, stocks, ETF’s, futures all have an implied volatility and a historical volatility. Historical is just that. It looks backwards and can tell us how volatile a stock has moved over a period of time. The option market’s expectation for future price movement is expressed in an underlying’s implied volatility. The more traders believe a stock will move, the higher the I/V.
To illustrate let’s examine the S&P 500 Index (SPX). The February options at the close today were trading with an implied volatility of 15.84%. Remember the higher the volatility percentage, the greater the expected move up or down. But what that number really represents is how much a one standard deviation move might be over one or many days.
Yes folks, we are talking about the dreaded bell curve! You remember from high school where you learned results will be within 1 standard deviation 68% of the time. And to know what a 1 standard deviation move will be tomorrow you need the following steps:
There are 252 trading days in the year. The square root of this equals 15.875. If your more inclined to do this in your head, feel free to cheat a bit and round up to 16.
Now you will take the underlying’s I/V % and divide by 15.875 to get the 1 standard deviation move for the next day.
Let’s go through a few examples to illustrate.
SPX I/V = 15.84
15.84/15.8745 = .997% (Go ahead and round up to 1%)
Netflix reported earnings last week. The day prior:
NFLX I/V = 149.27%
149.27%/15.8745 = 9.4% 1 day move expected!
Finally, we’ll reach back into the archives. Back in 2004 Martha Stewart was due to be sentenced in the insider trading case. Right before sentencing was announced:
MRO I/V = 339.01% WOW!
339.01/15.8745 = 21.36% expected move up or down in 1 day!
Now the move could wind up being more or less than expected. What we can see though is what the options market through the pricing of options is saying they believe a range might be. Many trading platforms will show you what the probability range.
Above we see the SPY etc. You’ll notice that as you move further and further out along the options expiration calendar, the probability cone widens. You might be asking yourself how to figure out the expected move not only for 1 day, but multiple days or months. It does get a bit tricky because each months options carry a different I/V, but in general if you follow these steps your’ll get a good idea.
Take the SPX Index with a 1 day move of 1%. Say you wanted to know based on the SPX current implied volatility what the options market is forecasting over the next 49 days? Simply take the square root of 49 which is 7 (now you see why I choose 49 days) and then multiply by the 1 day expected move.
So 7 x 1 = 7%.
Options traders are essentially either buying or selling volatility to some degree. As we continue through earnings season, keep an eye out for the expected move and then see which stocks moved more or less that the market thought.
Volatility has returned to the options market after the S&P 500 declined 63 points (3.4%) in just 3 days. The VIX had an out sized jump comparably as it moved 4.6 points (36%) over the same time. However, in the big picture of things, this is still not considered a high level by most standards. For example this latest peak failed to reach any of the highs of 2013 and barely surpassed the average for all of 2012 which was 17.8.
For those of us who sell volatility for income, this pop is a welcome one I’m sure. Short puts as entries and short calls to generate income off long positions will feel a little better this week. However, the cost of hedging on a relative basis is still low, so if you’re looking to protect after this move, it’s not too late. Buying the 1600 puts on the SPX will give you protection below a 10% drop at an annual cost of 3.5%.
So, what do we see in the market?
A slight uptick in volatility. It is a slight uptick now – but if this sell off has any lasting power, it won’t stay that way. Volatility will spike and the price of all options will go up – your cost of protection especially. I hope you have been following our advice since November and looking to lock in some attractive put protection while the cost to hedge was near historic lows.
A flight to quality. Treasuries have trended up for the last 3 days and hi-yield and junk bonds are trending down. Sell-offs spook people and they often go to safe havens while waiting out the market turmoil. If the pull back continues, I would really like the purchase of HYHG – the hedged Hi-yield product from ProShares. I would expect the product to out-perform when the market gets closer to its equilibrium level.
Apple will impact markets. Apple has earnings after market today. In fact, one some level, I think that is why the market move today is somewhat muted. Apple is a meaningful part of the NASDAQ and S&P 500 – and a barometer for many supplier firms and the technology industry. After the market close today, Apple will report its numbers – which should create a fairly interesting move for the markets either way this week.
These three points above are all short-term and tactical. At Buy & Hedge, we are long-term investors. These moves are only material to our entry and exit approach – not the strategy itself. Be hedged – and pay as little as possible for the protection from the hedge. Always.