The second quarter of 2023 saw equities remaining resilient despite concerns about rising interest rates, with tech and consumer discretionary sectors performing well.
The decline in realized volatility and absence of big moves have affected strategies that own short-dated options, emphasizing the importance of risk management and evaluating the value of different options.
Deep dives
Overview of the Second Quarter of 2023
The second quarter of 2023 saw various themes and developments in the market. The SVB debacle, which led to a deposit flight and increased volatility in short-dated rates, highlighted the risks of rising interest rates. However, despite concerns about higher rates, equities have shown resilience, with tech and consumer discretionary sectors performing particularly well. The VIX remained stable, and the stock-bond correlation showed signs of returning to more traditional negative levels. Realized volatility in the S&P was low, and option pricing reflected a lower demand for insurance. Diversification remained important as different sectors delivered significant return dispersions.
The Importance of Big Moves in Volatility Trading
Big moves in asset prices play a crucial role in determining profits and losses in volatility trading. Large one-day percent moves have a significant impact on realized volatility and allow for the convexity of delta-neutral option positions to come into play. The decline in realized volatility and the absence of big moves have affected strategies that own short-dated options, such as the VXX. The pricing dynamics of these options depend not only on their nominal prices but also on their implied-to-realized volatilities and the forward-looking set of risks. Consequently, risk management and evaluating the value of different options are vital considerations in the current market environment.
The Dynamics of Stock-Bond Correlation
The correlation between stock and bond prices showed a return to more traditional negative levels in the second quarter. A growth shortfall or a shock to risk appetite provided space for bonds to rally as stocks fell. However, it is challenging to predict the direction of this correlation as the Federal Reserve continues to combat inflation. The short-term forward spread and the S&P's correlation with two-year yields indicate a shifting relationship between stocks and short-term interest rates. Managing exposure to equity markets and considering hedging strategies, such as buying puts or put spreads, is critical due to current valuation disparities and the potential risks associated with monetary policy.
Evaluating Option Pricing and Gold's Role in a Portfolio
Option pricing and the role of gold in a portfolio were discussed. Option pricing depends on various factors, including carry, credit, calendar, concern, and capital. The pricing of options, especially upside calls, reflected the current market environment. Considerations of implied volatilities, realized volatilities, and the forward-looking risks are crucial when evaluating option prices and their value. As for gold, it can serve as a hedge in risk-off environments when interest rates quickly fall. While gold initially performed well during the SVB debacle and debt ceiling uncertainties, its recent performance has been hindered by rising yields. However, the low two-month gold volatilities present an opportunity for investors.
Your host is back again, providing some thoughts and commentary on the recent period of low volatility in the equity market. With SVB and the debt ceiling uncertainty mostly in the rear-view, markets embraced the calm, experiencing just a single 2% up move and a single 2% down move in the first half of 2023. I break down the causes and consequences of lower volatility. Along the way, you’ll hear some talk on the gamma/theta trade-off, stock bond correlation, the price of upside calls in the S&P 500 and what appears to be an attractive level of implied volatility for gold. Hope you enjoy!
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