Strategies for Increased Market Volatility

When traders and investors turn largely bullish, they decrease buying protection to hedge their bets against market declines. They become 'complacent' and market volatility falls. A visible account of this complacency and lack of volatility can be seen in the VIX - generally considered a 'fear index' on the US S&P 500 stocks. Reviewing the slightly downward sloping support line for the VIX on the five year chart below, we see the VIX recently traded at levels not seen since before 2007. Although a very bullish sign for the equity markets, these levels are unsustainable. Therefore, we are currently interested in providing our clients exposure to a positive move in the VIX representing higher volatility and lower equity prices.

We have three trade opportunities in development. The lowest risk, longest term play is a 'managed certificate' that trades the moving average of the VIX with either a long or short bias. In general, this is a great way to hedge a bullish (or 'long') equity portfolio. This certificate trades the VIX 'short' almost 80% of the time, so its value increases as volatility falls. However, when the 4-day moving average of the VIX moves higher, the certificates allocation changes from a short bias to a long bias. This means that spikes in the VIX would be captured as gains also.

A more aggressive and timely opportunity would be selling a VXX put (within an decreasing autocall note). VXX is an index ETF that aims to track the movements of the two front months of VIX futures. Selling a put is a bullish position that enables investors to get paid a premium as long as the price of VXX does not close below the strike price of the put option. With VIX and VXX at all time lows, a timely sale of far out-the-money puts on VXX can yield an easy 15%+ annualised rate of return. This is a not a long term holding strategy to hedge a bullish portfolio, but a rather safe bet at making a good short term trading return.

Finally, we are evaluating a 2X leveraged mini-future March 2013 contract with a stop-loss. With VIX extremely low now for an extended period, we are consciously practicing patience while we wait for the first signs that SPY is about to roll over. We find this strategy enticing for investors who want a direct play on the VIX with a leveraged move. Again, looking at the graph above, when the VIX moves up it moves in leaps and bounds! Today alone the VIX was up over 5% on a flat trading day in the markets. Imagine what would happen if market volatility really returned with vigour. Trade size is especially important with this type of product, so we are working to get this product to clients for as little as USD 10,000, with daily liquidity, transparent pricing and the ability to scale into and out of this product.

For information on this note, and others that can hedge a bullish equity portfolio, follow us on Facebook or sign up for our structured product mailings.

Author: Chris Davies  

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A Golden Opportunity in this Structured Product

Almost daily we receive Structured Product offers in our emails from various brokers and banks, such as EFG, UBS, RBC, Commerzbank, Deutsche Bank, and Nomura. As we discussed on our Facebook page, we advise clients when the can achieve the best prices and the highest probabilities of a positive outcome on their investments into structured products by using the CBOE SKEW and VIX measures. Currently, we do not see compelling reason to enter into bullishly oriented structured notes with equity underlyings, but we do see opportunities to hedge our clients' bullish equity bets in the market.

One interesting and timely structured product note focuses on the out-of-favor gold-mining sector (mainly represented by the two ETFs GDX and GDXJ). This sector has not participated in the recent equity bull run that has taken place since mid-November of 2012 which now seems a bit overbought in the near term.

Four stocks make up the underlying investments in this note. The 1-year charts below show these stocks are treading water as the market has risen lately.

Possible bottoming pattern if this makes a high low on this pullback

Flat base pattern with oversold momentum and price oscillators

Weak down trend with bullish divergences in the oscillators

Flat base at support from March 2012

Obviously, we expect further declines in these 4 stocks if the market continues to go higher. So why would these be interesting to own in a structured product note?

As we previously mentioned, we view this opportunity as a hedge of our bullish equity posture in today's market environment. If the equity market does start a pullback, the gold miners could rally. These stocks are are correlated with the movement of gold prices (represented best by the ETF GLD), which is viewed as an anti-inflation and, more generally, a "risk-off" trade.

How this note is structured also makes it an interesting opportunity. Investors will get paid even if these stocks fall! The note pays a coupon as long as none of the 4 stocks fall more than 35% in any quarter. Looking at the charts above, we know that all these stocks would have to trade lower than they did anytime in the last 12 months to put the investors coupon at risk. From a pure statistical perspective this is highly unlikely to occur. Unless these stocks fall to new 52-week lows, investors collect a quarterly income.

Meanwhile, if these stocks all trade at 95% or greater (at the end of any quarter) than where they are priced today, the notes also pay a coupon, Further, the note has an autocall feature meaning the note returns the investor's principal along with the coupon.

This note is an example of how structured products can make investors money when stocks go up, go sideways, or even go slightly down. With a capital guarantee on this structured product as long as none of the 4 stocks trade below 50% of their current price at the end of four years (on that single date only), investors should feel comfortable that the probabilities of success in this investment are extremely high.

For information on this note, and others that can hedge a bullish equity portfolio, follow us on Facebook or sign up for our structured product mailings.


Author: Chris Davies  

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Pricing Structured Products Around Oil

Lately, we have been working hard to develop high coupon auto calls based on the price of oil. Creating auto call notes on commodities is difficult, if not impossible, as the commodity indexes do not follow the spot price of the commodity due to contango in the futures term structures. None of the details of why this occurs are important to most investors, so lets get to what does matter.

If we cannot create auto calls on oil directly or on ETFs like USO, we can try and price them on oil related stocks or on ETFs that invest in oil related stocks, such as OIH or even XLE. This is what we are working on currently.

So far this is the pricing we have from a AA- rated bank:
· 5 years term
· GBP
· Basket of XLE, FTSE 100 and S&P 500
· Semi-annual observations
· 100% autocall trigger
· 50% European barrier
· Snowball coupon
· 7% per annum coupon
If the European barrier is increased to 60% the coupon rises to 8% per annum. Still, this is not very enticing!

This does compare with another product that we have seen being discussed actively, including recently on our own Structured Products page, that uses the Excess Return Oil Index (which does a lousy job of tracking oil spot prices) with a 50% American barrier (which we would not recommend) yielding a coupon of 9% per annum. Again, neither of these products “shoot the lights out”, but using an index of stocks rather than a commodity index has big impact on reducing volatility (and therefore returns).

If 8-9% annual returns are just too low, lets discuss what pricing is interesting in relation to some current products available.

One structured product marketed currently is an income note with a 9% annual coupon over 1 year on a basket of Repsol, Halliburton, Gazprom and Chesapeake Energy. We are not big fans of the the basket, but we have priced this product with a much higher 14.4% annual return with a better rated bank! An autocall on the same basket over 2 years would offer 25.5% per annum. The product would autocall quarterly as long as no basket members have fallen by 20% or more. This '80% or more corridor' is truly massive for an auto call note and is worthy of investors' attention.

Author: Chris Davies

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