We're often asked what one should do in a low-volatility environment. Is it advisable to continue selling volatility?
The only answer, although somewhat trivial and non-informative, is it depends.
The key question to consider is whether volatility is expensive or not. This consideration should be independent of context and regime.
You'll find great setups for selling volatility in a low-volatility environment. Conversely, an environment with extremely high volatility can be detrimental to a short-volatility strategy.
At Sharpe Two, we prefer to remain agile and fluid, considering both long and short trades in the volatility space.
That being said, today, we lean towards the long side of volatility. This stance isn’t because we foresee an apocalyptic end but rather because we believe that, with the market readjusting post-2023's explosive finale, the insurance premium on major equity indices might still be undervalued.
Let's dive in.
The context
Our equity regime indicator has just signaled that we've entered a phase where the QQQ is experiencing a sell-off. This period is typically not ideal for maintaining an actively long position in the market, especially with a short-term mindset.
This phase also tends to be a time when volatility rises, creating a potentially lucrative playground for those selling short volatility.
However, it's wise not to jump in too hastily. We need to be reasonably confident that the majority of the market movement has occurred. Besides, with significant macroeconomic data on inflation and GDP on the horizon, along with the start of the earnings season, there are plenty of catalysts that could induce stocks to fluctuate more than what is currently priced in by market participants.
Two quite opinionated camps hold opposing views: one believes the market's expectation of six rate cuts is overly optimistic, and the soft landing might still turn hard. For them, trading so close to all-time highs is absolutely unjustified, and they expect the equity to significantly pull back from their current levels.
The other camp thinks that the worst is behind us, and with a strong economy, companies that are currently thriving should continue to do so as long as job stability remains. Needless to say, not only are they comfortable with the current stock valuations, but they are also poised to buy even more if the latest economic data validates their thesis.
We prefer to steer clear of this debate. However, one fact is certain: the realized volatility in QQQ has been gradually increasing from its two-year low observed in December 2023.
As investors remain captivated by last year's lackluster performance, we believe that the cost of insurance is still relatively inexpensive compared to the potential magnitude of movements, whether on the upside or the downside, that we might witness.
Let's delve into the data.
The Signal and Trade Methodology
When searching for opportunities in the volatility space, we start by comparing the price of an at-the-money straddle to the actual movements of the underlying asset. In practice, this often involves averaging the movements over a specific period.
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