In mid-August, at the height of the North Korea geopolitical turbulence, and amid uncertainty about the Fed balance sheet unwind, fears of a government shutdown and the US debt ceiling, as well as the fate of Trump tax reform and Obamacare repeal, when the VIX soared following a series of missile launches by Kim Jong Un only to crash right back to near all time lows, we used an analysis from BofA’s derivatives analyst Benjamin Bowler to show “How To Hedge A Near-Term Market Shock: Here Are The Best Trades”
As we said then “if the events from last week demonstrated something, it is that just when there appears to be virtually no risk, is when the likelihood of a historic surge in volatility is greatest, as many experienced first hand last Thursday. Hence the need to hedge. But what? And using which product?” As Bowler explained “the decision about whether it’s rational to hedge is really a matter of looking at the price of tail insurance embedded into option markets and asking if the probabilities they assign are ‘fair’ or not.” As he further wrote, when it comes to predicting what the next “severe tail event” could look like, “we find that not only are some markets like Gold pricing in a very low probability of Korean risk escalation, there are significant differences across assets in terms of what they imply about potential risks.”
He then presented the chart below which shows how historical worst 3M drawdowns since 2006 are priced by 3M 25- delta options across asset classes; hedges that are most underpricing their historical drawdowns are at the top and those most overpricing their tails are at the bottom. What the chart shows is that gold call options imply less than a 1 in 100 chance of a severe tail event over the next month, despite being among the most reactive assets to rising Korean tensions last week. With record low Gold vol slaved to record low real rates vol, this represents a loose anchor which likely won’t hold in any significant geopolitical risk escalation. In contrast to gold, Nikkei is at the other end of the spectrum with options assigning over a 5% chance of a near term tail-event.
This post was published at Zero Hedge on Oct 3, 2017.