What If The Selling Isn’t Over: Here Are The Cheapest Ways To Hedge The Next Crash

Last week’s relentless selling appears to have paused amid speculation of a global coordinated monetary and fiscal response, but is the risk truly gone, or has today’s brief respite – on hopes of intervention – simply raised the odds of an even greater crash in the coming days? And if so, what is the best way to hedge?

That is the topic addressed today by Morgan Stanley’s Quantitative Derivatives Strategies, which looks to find the least expensive hedges to further downside.

As MS director Chris Metli writes, a tentative rally in equities gives investors an opportunity to look at how to protect any renewed selloff, especially since, as Metli observes, one place where not to look for cheap hedges is US stocks. As Metli explains, US markets have already suffered a 13% drawdown from peak (15th worst 1½ weeks since 1990), and implied volatility on almost all sectors and global indices look nearly the cheapest they’ve ever been relative to implied vol on the S&P 500 (only hedging the Kospi is more expensive).

While this dynamic favors put spread collars for hedging S&P 500 risk (particularly on bounces), QDS thinks the better places to buy downside optionality are:

• On indices in Asia which have lower implied vol (relatively speaking) and haven’t fallen as far from peaks as US markets
• In the US on Technology where investors remain hiding out in crowded longs and are at risk if HFs get drawn into the selling and there is a degrossing
• Or in Defensives which could continue to suffer more relative to what is implied if downside moves continue to be highly correlated

A few datapoints to put in perspective how rich volatility is broadly and in particular on the S&P 500.  First, implied volatility for many indices is trading more than 3 standard deviations rich relative to the last 5 years.  Second, S&P 500 implied correlation has risen to levels last seen during the Feb 2018 volatility spike – which was the epitome of a high correction event (driven by technicals on the S&P 500 itself).  Third, implied volatility is trading in-line with recent realized, which is unusual during a vol spike.  Typically as realized volatility spikes (i.e. in Aug 2011, Aug 2015, Feb 2018, Oct 2018, Dec 2018) implied volatility levels beyond very short-term expiries lag as the market prices in some normalization after the spike – but today, the market is clearly worried about a continuation of stress and uncertainty.

As shown in the charts above, while volatility is not cheap anywhere, it is relatively cheaper in Asia and Europe than in the US according to MS.  But why are US hedges so expensive? The reason why the US has repriced the most violently because it is the liquid high quality equity asset, which reacts the most (relative to baseline pricing) to uncertainty and risk premium.  But as certainty over economic ramifications grows, the risk premiums should shift back to the areas with the most direct impact.  Implied vol for EEM, HSCEI, HSI etc. relative to SPX are all on the lows relative to history.  April 5% OTM HSCEI puts cost 2.4%, compared with 3.3% for S&P 500 5% OTM puts (roughly, things are moving around a lot…).

For those who don’t want to bother with complex derivative bets, there is a simple alternative: gold upside remains an attractive hedge and entry points are slightly better now than before the underperformance late last week.  With upside skew remaining steep, call spreads are attractive and only price 0.6 standard deviations rich here, relatively attractive in this high volatility environment.

What about those traders who need US-based equity hedges? According to Morgan Stanley, it favors owning volatility on Nasdaq/QQQs or Defensive sectors. as “both look cheap relative to the S&P 500, while the 3rd leg of the market – Cyclicals and Financials – is where implied volatility has risen the most.”

Meanwhile, as we have written extensively over the last two weeks, QDS continues to see risk of an unwind in the crowded longs, with hedge funds until recently trading under the most leverage on record.  Such an unwind could either happen if global growth expectations fall further (these stocks work in the muddle through, not the recession case) or if there is a shock to HF P/L that forces a derisking. But the latter in particular would result in a relatively high dispersion / low correlation market, another reason to focus on sector or single-stock hedges rather than S&P 500 hedges at these vol levels. With Technology skew steep put spreads make the most sense for QQQs in QDS’s view; a April 40-20^ put spread can protect a 9% range of downside costing roughly 2.3%.

There is another sector that could be hit disproportionately should the selling resume: since the selloff began Defensives have outperformed, and implied volatility remains low – despite the price action of the last two days when these trends reversed.  If uncertainty remains elevated and the highly correlated selloff persist, Defensives could move lower with the rest of the market, and then downside protection here offers the best risk/reward relative to current pricing, according to Metli. Indeed, XLU 1m 30^ puts cost roughly 1.7%, indicative.

Finally coming back to the S&P 500, put spread collars line up well given the elevated volatility.  Investors can buy the SPX April 2900/2700 put spread and fully offset the cost by selling the 3125 call.  This protects a 6.7% wide range in the S&P 500 starting down 2.6%, at the cost of giving up upside beyond +5%, an attractive risk/reward in QDS’ view (indicative, ref=2977).