Capitalizing on Low Volatility

In the world of structured notes and option strategies, the prevailing belief is that low volatility equates to fewer opportunities. However, this couldn't be further from the truth. By constantly scanning listed options, we can gauge market conditions and determine the best structured notes to deploy.  There is always an opportunity if you know where to look.  In this post, we'll explore which structures actually price better during periods of low volatility.  

Listed option call spreads give the exact same payoffs as a Capped Growth note.  In the world of structured notes the name of the game is to maximize how much upside you can receive on these trades at any point in time - a trade with the same underlier and tenor that allows you to capture 50% of the upside is far superior to one which allows you to capture 40%. 

So what is it that determines how much upside a note can actually capture?  Let's examine… 

Explanation of the Analysis:

To demonstrate, we modeled options prices assuming the SPY was trading at $500. We analyzed the prices of several SPY call spreads with a 3-year expiration, varying both the strike prices and the implied volatilities (15%, 20%, and 25%).

A call spread involves buying a call option at a lower strike price and selling another call option at a higher strike price. This strategy caps the potential profit but also reduces the initial cost compared to buying a single call option outright. The lower the cost of the spread the better for returns

Below is a table showing different call spread strikes and the price of the spreads in times of lower and higher volatility. The call spreads start by giving 20% upside from the current price of $500 (SPY goes from 500 to 600) and end at 50% upside (SPY goes from 500 to 750).

Results:

For the 20% and 30% upside structures the difference between volatility periods is very negligible. In times when volatility is 15% and in times where volatility is 25% the cost between these spreads is under .5% of the SPY price.  

However, look further down the chart to the 50% upside spread. The difference between spreads is quite meaningful here at almost 2% of the SPY price.    A further look at the chart shows that the cost for 50% upside when volatility is at 15% is less than 40% upside when volatility is at 25%. That is a massive difference in potential returns returns

It's actually CHEAPER to put on a capped growth note that captures 50% of the upside when volatility is low compared to when volatility is high.

Conclusion:

Many advisors and practitioners believe that when volatility is low, there are no interesting opportunities in structured notes. However, the reality is quite the opposite. Our analysis demonstrates that certain structures are not only viable but also potentially more cost-effective during periods of low volatility. This contradicts the common belief that low volatility environments lack lucrative opportunities. 

There are always opportunities if you understand how to leverage the tools available. For personalized advice or more information, contact us today. 

Need Expert Analysis?  Forward any note to askus@marinelayeradvisors.com for instant review

Practical Guide to Buffer vs. Barrier protection

By their very nature the Options and Derivative instruments within Structured Notes can be complicated.  Navigating through the multitude of choices that are available can be overwhelming for the Advisor looking to find the best solution for their clients.  This is where experience helps a great deal.  Having Derivatives experts who have traded these products and can harness their power as well as clearly articulate their risks is of the utmost importance. 

In this section we’ll discuss the very high level differences between Buffer and Barrier Options (Equity Knock In - EKI) as they are most often used within Structured notes.  More importantly, we’ll discuss how one should think about them. 

Buffer options are similar to options available in the listed market.  They have a set strike price and start to gain or lose money only once the underlier passes through that strike price.  Barrier options (EKI) also have a strike price but the difference lies in their payoff.  Once the underlier passes through the strike price the Barrier Option doesn’t just begin to lose money from that point on - it instantly loses the amount from the starting underlier price to the strike price.  

Let's think about it in terms of a game where we have $100 and 10 doors in front of us.   

In game number one - behind 5 of the doors is someone who will give us $50, in the other 5 doors is someone who will take $20 from us.  The expected value of play this game would be 50% * $50 + 50% * -$20 = $15.  So if you were to play this game an infinite amount of times you would expect to win, on average, $15 every time.

In game number two - behind 8 of the doors is someone who will give us $50, but this time in the other 2 doors is someone who will take $125 from us.  The expected value of play this game would be 80% * $50 + 20% * -$125 = $15.  So if you were to play this game an infinite amount of times you would expect to win, on average, $15 every time.

So the expected value of both games is a positive $15, but don’t let that fool you.  The distribution of outcomes is very different from one game to the next - as evidenced by the Standard Deviation difference of one from the other. Game two may result in more frequent positive outcomes but the negative outcomes hurt more.  Managing the cash flow in each of these scenarios is very dependent on the situation at the time. 

The following graph shows a random sampling of payoffs after playing this game 200x.  Over time both lines will converge to the expected value of $15 per game but they take very different paths to get there.  As you can see from the illustration Game 1 tends to hover around the expected value in a tighter band than Game 2. 

For a real world example of this - take a look at the following graph that shows the Peak-to-Trough losses from playing the two games.  Game number 2 has much higher variance and carries a risk of far greater drawdowns.

In this simple example, game number 2 is more akin to a Barrier and game number 1 is more like a Buffer.  Neither is “right” nor “wrong” - but they have their time and place within a portfolio. 

In times of low volatility both Buffer and Barrier options decrease in price.  However, Barrier options decrease in price less on a proportional basis than Buffer options and thus can be a useful tool for adding returns to a note or a structure in order to add yield and make it interesting for investors.  However, it should be thought about in the context of an entire portfolio and not on a stand alone basis. Managing the risk of these positions during times of stress can be difficult. In high volatility environments,  Buffer options can add yield to the portfolio while maintaining their easy to manage risk/return profiles.  

While there is no “one size fits all” answer for these questions there are probabilities attached to these investments that should be thought about rigorously and exactly how they fit into the pieces of an overall portfolio.

Let our experts help you get the most out of your notes. Reach out at askus@marinelayeradvisors.com for expert analysis on any note.