Regional Index Options Could Cushion Equity Drawdowns
Equity markets have become more volatile in recent years. Our analysis shows that median volatility rose to 19.4 (2019-24) from 14.1 (2014-19), largely in response to the COVID-19 pandemic and geopolitical and macroeconomic events.1 This greater uncertainty has also led to U.S. index- and equity-options volumes doubling in 2023 compared to 2019.
What is the market's perception of volatility going forward? Post the volatility spike on Japan's Black Monday, implied volatility (based on at-the-money options) has risen again in several regional markets as of early September. Furthermore, the term structure of options inverted across all regions, an indication that investors perceive higher short-term risks than long-term risks. Despite perceptions of heightened risk, put-option premiums are still trending below their median, based on the last five years of data, potentially suggesting a lower cost to insure against heightened volatility.
Options strategies have offered protection in the past
Over the last 18 years, options strategies linked to the MSCI Emerging Markets (EM) and MSCI EAFE Indexes have provided downside protection and exhibited lower drawdowns during turbulent markets. Our analysis indicates that conditions similar to those we observed in EM and EAFE, such as higher volatility and inverted term structure, currently exist in other regions.
As global markets continue to face risks that include market concentration, crowding and a possible hard landing, understanding regional perceptions of near-term risks and the historical performance of options strategies during volatile periods can offer valuable insights for managing market uncertainty.
Options' implied volatility rose in September after August spike
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Data from Sept. 3, 2019, to Sept. 06, 2024. Implied volatility is based on the average implied volatility of 30-day at-the-money (ATM) call and put options. Term structure is calculated using the 91-day to 365-day implied-volatility ratio of ATM options. Put option as a percentage of spot price shows the premium of a three-month 95% put option. Options linked to the MSCI EAFE, MSCI Emerging Markets, MSCI ACWI and MSCI World Indexes were used to calculate the metrics shown for the EAFE, EM, ACWI and World regions, respectively. Metrics for the U.S. equity market were calculated using options linked to the S&P 500 Index through March 18, 2024, and then options linked to the MSCI USA Index. Source: OptionMetrics
Regional near-term risk perceptions vs. Japan's Black Monday
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Regional Variations in Volatility to Japan’s Black Monday
After the Bank of Japan’s rate hike on July 31, equity market volatility rose sharply. Emerging and EAFE markets were less volatile than the U.S., but their volatility spreads veered in opposite directions, with the EM/U.S. spread hitting a record low.
Systematic Options Strategies Linked to Regional Indexes
Our analysis of data spanning the last 18 years indicates that systematic options strategies linked to the MSCI EAFE and MSCI Emerging Markets Indexes have consistently exhibited lower risk and lower drawdowns compared to their parent indexes.
Understanding Geopolitical Risk in Investment
Over the last 30 years, high geopolitical risk has been associated with lower equity returns and higher forecast volatilities. We show that measures of geopolitical risk have provided useful information beyond conventional measures of uncertainty.
1 Data periods are from Sept. 2, 2014, to Aug. 30, 2019, and Sept. 3, 2019, to Sept. 6, 2024. Equity volatility represented by the Cboe® VIX® Index.
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