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EQDerivatives: VSTOXX® Upside Calls Offer Risk Reward Protection

Release date: 03 Dec 2018 | Eurex Group

EQDerivatives: VSTOXX® Upside Calls Offer Risk Reward Protection

Article by Georgia Reynolds, EMEA Reporter

This article first appeared in EQDerivatives' subscription Commentary & News service.

Institutional investors are looking at unhedged VSTOXX upside call options that offer attractive risk-reward protection against potential market dislocations. This comes following the ongoing macro risk factors in Europe such as Brexit uncertainty, Italy’s ongoing negotiations with the EU surrounding the deficit target, ECB potential change of policy in asset purchases and political instability in Germany.

The negative economic headlines are not translating into European volatility metrics and vol is trading at cheap levels, said Reda Benali, index derivatives trader at BNP Paribas in London. “VSTOXX is low as an absolute level, trading sub 20 vols and below the VIX, while implied VSTOXX volatility and skew are even lower, reaching the 15th percentile levels over last two years,” he said. Investors can take advantage of the cheapness of the skew by buying upside calls financed by selling downside puts at a reasonable floor. “For example, buying a January 30/40 call spread and selling a 15 put around a flat premium as a pure directional volatility play,” he said. Another structure is to buy January 30 calls on the VSTOXX and sell the January 30 call on the VIX while receiving a net premium for the trade. This is an effective relative-value trade to isolate European risk given the U.S. tail risk has disappeared due to the VIX ETP convexity, he added. “These are the two most popular trades since implied volatility and skew of VSTOXX are at extremely low historical level as a standalone and in relative to VIX implied volatility,” Benali said.

Alexandre Capez, partner at Mariana in London said unhedged VSTOXX upside call options offer good risk reward against market dislocations as first and foremost forwards are not excessively high, and the term structure is flat, close to 18.5. “This means less risk of volatility rebasing lower, [with] no carry cost at present,” he said. Due to the shape of VSTOXX futures term structure Capez favors longer-term options. “One can buy for instance a March 2019 30 call for roughly EUR 0.6,” he said. Additional drivers include the fact that implied volatility of volatility is trading close to the lowest levels over the past year and vol-of-vol skew is depressed, making upside VSTOXX calls inexpensive in premium terms.

“Should markets stabilize or even rally from where we currently are, I do believe volatility as well as vol-of-vol should hold well, allowing to roll the position further out in a month’s time to avoid the typical drag when we get too close to expiry,” Capez said. “In [the] case of a sharp market drawdown one could expect to benefit quickly both from a spike in vol and vol-of-vol, not to mention the liquidity premium of holding VSTOXX options by comparison with VIX options,” he said. 

Georgia Reynolds is a reporter at EMEA at EQDerivatives, based in London.
A recent graduate from City University London, Georgia has been studying and producing print and multimedia journalism for five years.

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