Hedging activity stays lively, despite volatility falling in August

Hedging activity remains robust despite overall market volatility levels falling during August, with sustained demand among hedge funds for volatility products holding up in recent weeks, according to new analysis by Man Group.

In a market commentary on Tuesday, portfolio managers at the London-headquartered publicly-traded hedge fund giant said relatively low realised volatility, coupled with a flood of short-dated options from a number of volatility sellers, helped drive the S&P 500’s weekly implied volatility to 6.6 on 13 August – its lowest level since 2017.

The latest weekly ‘Views From The Floor’ commentary rounding up Man portfolio managers’ perspectives explored recent call and put option activity, noting how high hedging flows have puts at relatively expensive levels.

“Despite short-dated at-the-money implied volatilities falling, hedging activity – as determined by equity skew – has been very robust,” they explained. “Skew is a measure of the implied volatility of out-of-the-money puts versus as-the-money or out-of-the-money implied volatility. The higher the skew, the more demand for calls or, potentially, higher supply of calls. Both are effectively hedges, with call sales capping upside and put buys capping downside.”

Meanwhile, certain factors – such as Value, Size, and Momentum – and sectors, particularly small-cap stocks, have continued to see volatile movements, even as S&P 500 volatility has remained comparatively low.

“One-month implied volatility on the Russell 2000 versus the S&P 500 reflects the very high realised volatility of small-cap stocks since the pandemic began, but also the expectation that it won’t normalise any time soon,” they said.

This suggests investors expect certain factor volatility to remain “much higher than for the broader market.”

However, Man PMs cautioned that not all asset classes are seeing hedging or higher demand for volatility products, noting that implied volatility on credit indices remains near lows.

“Since the Federal Reserve announced programmes that could buy credit in dislocations, equity implied volatility has persistently stayed at relatively high levels, compared with credit volatility.

“While this may imply that market expectations are for smaller dislocations in credit given Fed support, we believe that those expectations miss a whole range of negative outcomes ranging from impacts of inflation, tapering and potential rate hikes to solvency and downgrade issues in the next crisis.”