Investing wisely in times of high volatility

• 

  Christian Ingerl
  Redaktor

Volatility is a constant feature of financial markets and is generally regarded as an indicator of risk. Under certain conditions, however, it can also present an opportunity. Structured Products allow investors to position themselves in volatile markets in line with their preferences. Depending on their risk appetite and expectations, strategies range from capital protection and yield optimisation to short-term trading.

Volatility triggers fears

Most investors view high volatility as a negative factor. Yet, as a purely mathematical indicator, volatility is fundamentally indifferent to whether markets are moving up or down. In practice, however, price corrections often occur abruptly and are accompanied by rapid counter-movements. Consequently, volatility is significantly higher during such turbulent phases than during periods of an “orderly” upward trend.

Strengthening the defensive position

As many investors view significant price fluctuations as undesirable, they avoid investing in shares. However, this caution means they are also missing out on attractive return opportunities. Capital protection products offer a potential solution to this dilemma: they provide a high degree of security even during periods of significant market volatility, as 100% of the nominal amount is generally repaid at maturity. Losses due to falling prices of the underlying – such as a share index – are therefore ruled out. However, this only applies at maturity. This is an important point: because capital protection products can also fall below the purchase price before maturity. The maturity should therefore match your own investment horizon. It should also be noted that the potential returns are generally limited. This is the price you pay for the increased security. For example, the potential to benefit from rising prices of the underlying may be capped. Often, the maximum return is also determined by a coupon fixed in advance. Investors should therefore consider, before making a purchase, whether capital protection and potential returns are in an appropriate balance.

Volatility as an opportunity

As noted at the outset, high volatility can also present an opportunity with certain Structured Products. How can this be possible? Let’s take a Reverse Convertible as an example. With this product, the issuer combines the underlying with the sale of put options on that particular underlying. For selling the puts, the issuer receives an option premium, which is the higher the greater the implied volatility of the underlying is. The issuer uses this premium to finance the coupon of the Reverse Convertible. It is, therefore, logical that higher coupons are possible during periods of high volatility. As the coupon is a fixed income component which is paid regardless of the performance of the underlying, it also provides a certain safety buffer.

High volatility = higher coupon

Let’s demonstrate this relationship with an example: given a moderate implied volatility of 15% for a share, a put option on that share which is at-the-money and with a maturity in one year costs CHF 4.98* according to the Black–Scholes option pricing model. In the case of a Reverse Convertible with a strike price of CHF 100 (= current share price), the issuer could, therefore, theoretically pay a coupon of 4.98% over the one-year maturity. If, on the other hand, the implied volatility of the share at the time of issue is 30%, a significantly higher option premium of CHF 10.84 could be achieved and (theoretically) a correspondingly higher coupon of 10.84% could be offered. But beware: in practice, other factors besides the volatility of the underlying also play a role in determining the coupon rate. These include, for example, the level of the strike price or any dividend payments.

Don’t ignore the risks

The formula “high volatility = high option premiums = attractive product terms” also applies to other types of Structured Products. This includes Barrier Reverse Convertibles, although in this particular case it is not a standard put that is sold, but a so-called down-and-in put. This type of put has two price barriers: in addition to the strike price, it also features a knock-in barrier. Bonus Certificates (the sale of a down-and-out put on the underlying) and Discount Certificates (the sale of a call with a strike price equal to the cap) also contain option components. Consequently, during volatile market phases, they can be structured with terms that, compared to a direct investment, sometimes offer a significantly lower risk profile. The catch, however, is that with such products, higher price fluctuations also increase the risk of a potential barrier breach – with correspondingly negative consequences for the payout. It should also be noted that price behaviour during maturity is influenced in the opposite direction by volatility. This means that, all other things being equal, rising volatility has a negative effect on the price of the product during the term, whereas falling volatility has a positive effect.

Important for traders

Volatility also plays a significant role for traders. This starts with the choice of product. In the case of a leveraged product such as a Warrant, the following applies: the higher the volatility, the more expensive both Call and Put Warrants are, all other things being equal. If volatility decreases, their price also falls, ceteris paribus. In times of volatility peaks, it may, therefore, make sense for traders to opt for open-end Knock-outs or Mini Futures. With these types of leveraged products, the price is hardly affected by volatility due to their structure.