When markets get volatile, you've got options
by Joshua Lisser and Ben Sklar, AllianceBernstein
Last monthâs simultaneous volatility spike and stock downturn were unpleasant surprises for investors. But in the spirit of making lemons into lemonade, we see them as reminders to think broadly about downside protection.
For most of the summer, developed-market stocks shrugged off signs of trouble elsewhere, including declines in commodities and emerging-market assets and Chinaâs worsening economic outlook. Even the chance of a Federal Reserve rate hike wasnât having much effect.
Then everything changed. Over a few days in late August, implied US equity market volatility, as measured by the VIX, tripled. And the S&P 500 Index lost almost 11%. The last time market risk had shot up this quickly was almost 30 years ago during the Black Monday market crash in 1987.
Why did so few investors see this coming? History provides some clues. Our analysis of past market declines found that markets rarely fall so suddenly without warning. In fact, of the biggest equity market declines over the past three decades, almost all came after a steady rise in volatility. August 2015 was one of the exceptions (Display).
Risk-Aware Strategies May Not Be Enough
That history may have caused investors to assume they could wait until volatility had drifted higher before shopping for downside protection. We think thatâs a lot like scrambling to buy flood insurance after the storm starts. By then, it will either be very expensive or not available at all.
Some investors may have relied on systematic risk-aware strategies that manage their allocation according to market-risk measures. These quantitative approaches adjust market exposure based on changes in the level of market volatility. That usually means selling equities as overall market risk moves higher and buying them when the risk level recedes.
These types of strategies can be effective when risk rises ahead of large market drawdowns, but they donât work as well when volatility rises suddenly, as it did in August.
Keep Your Options Open
So how can investors protect themselves? One way is to buy put options, which give the holder the right to sell a security or an index at a predetermined price. Profits on these positions can help offset losses during market declines.
Many investors might resist this approach because it can be expensiveâand they wouldnât be wrong. Our studies show that using these simple buy-and-hold put strategies for protection can reduce returns by 3% annually. To lower the cost, some investors might try to tactically hold put options, timing the purchases according to their view on the market. But that approach itself can be risky. As Augustâs sudden volatility spike proved, getting the timing right is easier said than done.
We think a more effective approach would be a dynamic one. For example, during periods of lower market risk, the program would hold more lower-cost option protection. When risks rise, it would hold fewer options and reduce risk by lowering equity exposure.
The dynamic program would also vary the tenor and strike price of the options while using delta hedging to further reduce costs. Call overwriting would generate income to offset the cost of the puts. This approach is designed so that the portfolio always has some level of protection. That helps to sharply reduce risk in all market environmentsâat a fraction of the cost of a simple buy-and-hold put strategy.
Based on our research, a hypothetical portfolio of 60% stocks and 40% bonds that uses this strategy would have lowered risk substantially over the past 26 years with little effect on returns. And it would have reduced large declines of 10% or more by 40%, on average.
Another important benefit of options that may not be obvious: they provide liquidity. When markets are falling rapidly and liquidity is scarce, investors may find it more difficult to rebalance their portfolios. In some cases, they may not be able to trade at all if heavy selling triggers circuit breakers and closes the market. Options provide protection even in these situations. They essentially function as prepurchased liquidity thatâs available when you need it most.
Our research shows that, over time, a carefully balanced risk-aware program that incorporates options tends to provide the most robust downside protection. When liquidity is scarce and markets are tumbling, it pays to keep your options open.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
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