Key Takeaways: Textbook fragility event plus Pavlovian snap back forebodes bigger risks this fall. W-trade to hedge fragility, credit for cheap tails, & sell VIX puts to fund S&P calls to chase upside without calling the top. Own EU snapback with less risk with riskies; BHP exclusion to weigh on FTSE divs, prefer Dec23+; Proxy hedge commodity risks.
Investing with fragility into the fall
In an unstable market, it can be futile to search for catalysts behind every shock. Instead, last week’s risk asset selloff validated our calls that fragility risks were rising (see 17-Aug GEVI: The calm before the fragility?) and that implied vol would remain above pre-COVID norms in 2021 (see our 2021 Year Ahead report).
The selloff has come and gone, and equities back at new highs will merely encourage more of the investor behavior that historically precedes larger fragility shocks. Seasonality and the impending turn in Fed policy only heighten risks going into the fall.
To hedge a bigger fragility event, we continue to favor the W-trade, while credit-based tail hedges currently offer best value. To cheaply own further potential upside without having to call the market top, we reiterate our preference for long SPX calls funded by selling VIX puts. The entry point is historically attractive and VIX will likely be supported by tapering risks around the Sep FOMC, even if equities go higher in the meantime.
Riskies in laggard EU indices; own snapback with less risk
Last week’s equity weakness was symptomatic of the fragility of markets in seemingly “calm” periods. While we’re still concerned about fragility risks going into the fall, it’s also important to recognise the potential of fragile markets to experience sharp reversals.
Indeed, last week’s sell-off has left some European cyclical sectors and the CAC index weaker than their historical macro sensitivities would suggest, and hence with the potential to “snap back” rapidly and/or potentially resume the year-to-date European equity rally.
This, combined with (now) steeper skew levels, enables compelling pricing for levered risk reversals on European indices, which can be safer than owning delta outright on the underlyings.
In particular we highlight the following underperforming high-beta index structures with historically attractive pricing: (a) CAC 2m 30d 1×1.5 risk reversals, and (b) Short 2m 30-delta SXAP put, long 2.2x DAX calls.