Using volatility for your own purposes

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  Serge Nussbaumer
  Chefredaktor

Many investors continue to underestimate the importance of volatility for their investment strategy and risk management. The intensity of fluctuation is usually understood as a risk indicator. However, phases of increased volatility also offer interesting investment opportunities that can be exploited through the use of structured products.

Fluctuations are of great importance for the conditions and price development of many structured products, as they contain an option component. The following applies to options: if the (expected or implied) volatility of the underlying increases, the value of both call and put options on this underlying increases. If, on the other hand, volatility falls, options become correspondingly cheaper. This correlation plays an important role in portfolio hedging, as corresponding hedging is usually carried out with put options or put warrants.

High volatility makes hedging expensive

Assume an investor wants to hedge a position of 100 ABC shares against losses. The hedge is to take effect in twelve months. The current price of ABC shares is CHF 100, so the investor buys 100 put warrants on ABC shares with a strike price of CHF 100 (at the money), a remaining term of 360 days and a subscription ratio of 1:1. With a moderate implied volatility of the ABC share of 15%, a put costs CHF 4.89 according to the option pricing model of Black and Scholes. For 100 shares, this results in an “insurance premium” of CHF 489 or 4.89% of the amount to be hedged (= CHF 10,000 = 100 ABC shares x CHF 100). With a higher implied volatility of the ABC share of 35%, hedging would be significantly more expensive. This is because in this scenario a put – all other things being equal – costs around CHF 12.79. The “insurance premium” is therefore more than twice as high. This raises the question of whether hedging at such high costs makes economic sense at all.

Collect option premium

While rising or high volatility makes traditional hedging more expensive, such phases are very suitable for a different type of risk management. We are talking about the use of certain structured products. The background: the buyer of a call or put must pay the option premium in the form of the price, while it is credited to the seller, i.e. the writer of the call or put. The higher the volatility, the higher the achievable premium. How this improves the risk/reward profile of structured products will be explained using the example of reverse convertibles.

A high coupon reduces the risk of loss

With a classic reverse convertible, the issuer combines the underlying asset (or a zero-coupon bond) with the sale of put options on this same underlying asset. The issuer receives an option premium for the sale of the puts, which is higher the higher the volatility of the underlying asset. He uses this to finance the coupon on the reverse convertible. It is therefore logical that correspondingly higher coupons are possible in times of high volatility. As the coupon is a fixed income component that is paid regardless of the performance of the underlying, it also represents a certain safety buffer. This applies if the underlying is quoted below the strike price at maturity and the RC is not redeemed at 100% of the nominal value. Instead, repayment is made either by means of a correspondingly lower repayment amount (cash settlement) or by delivery of a number of shares determined by the subscription ratio that have fallen in price (physical delivery).

Remarkable effect on the coupon

Let us illustrate the relationship using the ABC share as an example. As a reminder: With an implied volatility of the share of 15%, the price or option premium per put is CHF 4.89. With a strike price of CHF 100 (= nominal value of the reverse convertible), the issuer could therefore theoretically pay a coupon of 4.89% over the one-year term. Scenario 2: If, on the other hand, the implied volatility of the ABC share at the time of issue is higher, at 35%, an option premium of CHF 12.79 would be achievable and, at least theoretically, a correspondingly higher coupon of 12.79% could be realized. Please note: In practice, in addition to the volatility of the underlying, other factors also play a role in the level of the coupon. These include, for example, the position of the strike price, any dividend payments that are also retained by the issuer to finance the coupon, and the issuer’s margins as a cost factor.

Large selection

The formula “high volatility = high option premiums = attractive product conditions” also applies to other types of structured products. One example is barrier reverse convertibles, in which a so-called down-and-in put is sold rather than an ordinary put. This has two price thresholds. In addition to the strike price, it also has a knock-in barrier. Bonus certificates (sale of a down-and-out put on the underlying security) and discount certificates (sale of a call with a strike price equal to the cap) also contain option components. In volatile market phases, they can therefore be equipped with conditions that have a significantly lower risk profile compared to a direct investment.

Please note!

Volatility also plays an important role after the issue or purchase date, i.e. during the term. However, the signs are reversed. This means that, all other things being equal, rising volatility has a negative effect on the price of the product during the term, while falling volatility has a positive effect.