Time to harvest volatility premiums?




Morgane Delledonne,
ETF Investment Strategist

The past couple of weeks have been a turning point for global markets, as investors acknowledged that the long-running bull market coupled with record low volatility have fuelled a dangerous exuberance that culminated in January’s rally.

Covered call strategies benefit from higher volatility

The sudden recognition that markets were potentially complacent about inflation has resulted in an abrupt change of volatility regime that has unlocked potential yield increases, as well as wider investment opportunities.

Past performance is not a guide to future performance. Stock market and currency movements mean the value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Investing in ETFs involves risk, including risks associated with market volatility, currency rate fluctuations, replication strategies, and changes in composition of the underlying index and assets.

Volatility surges amid uncertain inflation

Market participants have been repricing a faster tightening path by the Federal Reserve, which has led to a correction across the overheated global equity market at the beginning of February. The revived inflationary threats and the possibility of higher rates that could erode corporate profitability have resulted in a burst of volatility. The VIX Index rose from 9% in early January to over 35% in the first week of February, before stabilising at around 20% as of 16 February.

While being an erratic data point rather than an inflationary trend, the stronger-than-expected rise of US wages in January was sufficient to trigger the market sell-off as it warned investors that inflation is returning, in accordance with the theory of the Phillips Curve – inflation rises with diminished slack in the labour market. At the same time, the Federal Reserve has entered a new era as Jerome Powell became chair, adding uncertainty over the future of path of monetary policy normalisation under this new leadership.

Profit taking rather than fear

The characteristics of the recent sell-off reflect a fundamental market correction rather than panic. In her final press conference, Janet Yellen stated that stock market valuations were elevated. In January, the price of the S&P 500 Index diverged significantly from its 125-day average without being supported by a significant improvement of fundamentals. This quickly reverted and despite the global markets sell-off, the demand for safe haven assets has been subdued, suggesting investors may have simply taken profits after the start of year rally, rather than any significant change in investment strategy.

We expect the high volatility to reverse back to its long-term average (15%) as the economic backdrop of synchronised economic growth and strong corporate earnings remains supportive for equities. However, we anticipate further bursts of volatility throughout 2018 amid higher market sensitivity to inflation. The US Treasury curve has repriced higher reflecting higher inflation expectations, and any monetary policy misstep could add to the current volatility.

How has the covered call overlay strategy held out in the recent market correction?

The spike of volatility that accompanied the global market correction has negatively impacted the enhanced income products as they are long the underlying stock index and, to a lesser extent, inherently short volatility, though they outperformed their respective benchmarks. The short volatility exposure comes from selling call options, which also provides the volatility risk premium when option market implied volatility is higher than the realised volatility. When markets fall and volatility climbs, the spot price of the underlying index drops and the call options move further out of the money, reducing the risk of being exercised and leaving the premium received by selling these options as a buffer against the index declines.

Our strategy is likely to benefit further in 2018 as higher volatility implies that writing covered calls will become more lucrative from increased premiums. Market downturns increase the volatility that the market participants are expecting (i.e. implied volatility). As a rule of thumb, when implied volatility increases (decreases), call premium increases (decreases). If the volatility level settles at its long-term average, the annualised option yield will increase from a target of 2% per annum in the previous low volatility (10%) environment, to around 3% per annum in the UK, US and Europe.

While both “inverse VIX” and covered call strategies incorporate a short volatility exposure (although of different magnitudes) they have opposite outcomes when the market falls and volatility spikes. In the chart below, we have illustrated a 100% covered call strategy on the S&P 500 Index with the BXY index[1], and compared it to the inverse VIX Index which is 100% short volatility. Unlike the inverse VIX index, the covered call strategy is defensive when market falls and volatility rises. Our Enhanced Income ETFs average 50% coverage of the underlying S&P 500 Index, in order to allow upside participation, but provide similar defensive characteristics in market downturns.

Looking ahead, if you are seeking income but also want to manage your exposure to the potential bursts of volatility that we believe are likely through 2018, a covered call strategy could well be worth considering.

Strategy Inception date LN Tickers Base Currency
BMO Enhanced Income Euro Equity ETF 07-Jul-17 ZWEE / ZWEU* EUR
BMO Enhanced Income UK Equity ETF 07-Jul-17 ZWUK GBP
BMO Enhanced Income USA Equity ETF 07-Jul-17 ZWUU / ZWUS* USD

(*GBP priced)

[1] The BXY Index or CBOE S&P 500 2% OTM BuyWrite Index is calculated using out of the-money S&P 500 Index (SPX) call options.

Shares purchased on the secondary market cannot usually be sold directly back to the Fund. Secondary market investors must buy and sell ETF Shares with the assistance of an intermediary (e.g. a stockbroker) and may incur fees for doing so. In addition, investors may pay more than the current Net Asset Value per Share when buying ETF Shares and may receive less than the current Net Asset Value per Share when selling them.

The information, opinions estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.