Volatility has surged from August lows, amid growing uncertainty around the U.S. elections, the path to economic recovery, progress on a vaccine and concerns over rising COVID-19 cases. Anthony Okolie talks to Jimmy Xu, Portfolio Manager, TD Asset Management, about how he uses options strategies to boost returns and reduce volatility.
- Jimmy, volatility spiked in September from the August lows when markets were trading at all time highs. Now fundamentally, we know that when stock markets rise, volatility tends to subside and vise versa. So help us explain why the sudden rise in volatility?
- Sure, Anthony. First of all, it's great to see you. And you're absolutely right. Volatility has risen quite substantially since the summer has ended. When you look at the VIX index, which is a measure of S&P 500 volatility, it has risen to levels that we actually haven't seen since last June. So the rise in volatility has been pretty substantial. If we take a closer look, we find that most of the volatility increase has been driven by the mega cap technology stocks. And because tech stocks are such a large component of S&P 500 now, rising technology stock volatility has driven up volatility of the overall market.
And I think one of the reasons why tech stocks has been so volatile as of late is because investor greed. We've seen both institutional and retail investors trying to chase upside in these mega cap tech stocks by buying up about $44 billion in premium of call options hoping that technology stocks will continue to its rise. We can sit here and debate whether or not this is the cause of the tech sell-off that we saw last month. But at the end of the day, when positions get one-sided and extreme, markets become more vulnerable to sell-offs, and we certainly expect volatility to persist over the rest of this year.
- Thanks. I think that's very important giving us that background. So why should investors brace for more volatility in the future?
- Yeah, volatility is really a reflection of investor confidence about the future outlook. And I think over the fall, there are a couple of events that could test that investor confidence. One thing that we're watching really closely is Purchasing Managers' Index. This is often seen as a leading indicator of both markets and earnings. We've seen a quite substantial improvement in the PMI index over the summer. So we'll be looking very closely to see if the recovery can continue in its current speed for the rest of this year. If not, investors might be concerned about future earnings and future growth which will lead to, ultimately, volatility.
And second is COVID. COVID is not over yet. If we look at Ontario, daily case counts now higher than where it has been over the first wave in the spring. And this isn't just a Canadian issue. It's not just an Ontario issue. If you look across globally, especially in Europe, which had fantastic virus containment measures during the first round, now we're seeing a resurgence of that virus in Europe, as well. And if you look at countries like Israel, they've entered into another round of lockdowns.
So if cases continue to rise here or in other large economies and we fall back into a lockdown, we should expect to see volatility at levels that's pretty similar to what we've seen earlier this year. And finally, for those who watch the US presidential debate this week, it's a reminder to investors that this is probably going to be one of the most controversial elections and contested elections in recent history.
And there is a high possibility that at the eve of elections, we actually don't know who the next president will be. And if this lingers on for, you know, until December or, worst case, until January, certainly the market will not like that. There'll be a lot of uncertainty and a lot of volatility. So investors should really brace for volatility in the fall because these two things are not going away.
- You also cautioned that investors should try not to panic when volatility increases. Now, that's easier said than done. But why is that the case? And how can investors benefit from this volatility?
- Absolutely. It's really easy for us to sit here and telling investors, hey, don't panic when markets are volatile, but it's really hard because everyone has a plan until they get punched in the face. Right? So what we found in our data is that investors tend to make bad decisions when there's volatility. So they tend to sell at the lowest and buy at the highs, especially of points of maximum pain which is, obviously, not a great investment strategy.
We think the best way to help investors avoid making these types of mistakes is to really insulate them from this volatility. And within our portfolios at TDAM, we use a wide variety of tools to do that. And they include cash cover puts, protection strategies, stock replacements, and even currencies to help insulate investors from that volatility so that they can have a smoother ride in volatile periods. And some of these strategies even benefit from a high volume environment.
- Can you give us an example of how you use these strategies in your portfolio?
- Absolutely. One of the strategies that we really like is something that we call cash cover puts. So instead of just sitting on cash in the portfolio and effectively earning nothing in this low rate environment, investors can sell put options against that cash on stocks they want to own at a lower price. So by selling a put option, what happens is we get to collect a premium upfront in exchange for the obligation to buy that stock lower at some point in the future. So the advantage of this strategy is that the higher the volatility, the more premium we can collect up front. And effectively, what we're doing is we're getting paid to wait to buy stock at a lower price.
- Now, also, whenever you talk about options, there's a lot of risks associated with these types of transactions. It's probably not something that investors should try on their own, correct?
- Yeah, that's absolutely right. Options can be very tricky instruments if used improperly. So with this strategy, one of the biggest risk is that if the stock price falls significantly below your obligated purchase price, effectively, an investor would be buying stocks at a higher price than its current market value. Obviously, that's not a great outcome. We try to mitigate that by only selling put options on stocks that we are comfortable with only lower, and that's really important. What you sell puts on really matters to the final outcome.
And second, options are just generally more complex for retail investors or even some institution investors, as well. They have higher transaction costs, higher bid ask spread, which is the price you can buy or sell at any given time. And especially, when markets are volatile, the bid ask spread is really wide and can be very expensive transacting in the options market. So it's really important to know how to access the market, when to access the market to get the best price possible. And when markets are volatile, certainly every penny counts.
- Jimmy, great information. Thank you very much for your time.
- My pleasure.