Volatility radar

Profit from low vol and high skew

4 April 2016
Chief Investment Office WM
Tze Shao, analyst, [email protected]

The CIO Volatility Radar is a monthly publication designed to guide

investors using volatility strategies.

Conclusion: 1) In the Eurozone, at-the-money implied volatility is

cheap combined with a steep skew. Short-dated volatility tenors
in particular are cheap. 2) This picture also applies to the Kospi
200: the at-the-money implied volatility is cheap combined with a
steep skew. Short-dated volatility tenors in particular are cheap. 3)
In the UK, implied volatilities have decreased, making Brexit hedging
cheaper compared to one month ago.

You must read this report if: You are seeking to take advantage of
lower levels of volatility and a high skew.
House view
This publication answers investors' three main questions about equity
index volatility: 1) Is market-implied volatility cheap or expensive? 2) Which
tenors are the most (or least) interesting? and 3) Are put options over- or
underpriced relative to call options?

Source: UBS, as of 30 March 2016

In most equity markets, implied volatility has decreased while the skew
remains steep. Below, we present a menu of ideas on how we can take
advantage of this situation.
Profit from low vol and high skew if you are bullish...
The three-month implied volatility of Kospi 200 is at the 23rd percentile
(relative to a one-year window) and its 90-110 three-month skew is at
the 74th percentile (relative to a one-year window).

The steep skew makes funding a long out-of-the-money calls via

"VIX near the lowest level since September 2015"

Source: Bloomberg, as of 30 March 2016

selling out-of-the-money puts attractive.

What if you are bearish?
Euro Stoxx 50 has recovered more than 10% from its February lows. We
can use put spreads to lock this in. The combination of low at-the-money
volatility with a steep skew makes put spreads cheaper.
What if you are bearish and want to hedge against Brexit?
The FTSE 100 implied volatilities have decreased compared to one month
ago. Back then, the term structure showed an unusual hump at the
six-month tenor, reflecting investors' anxiety in advance of the Brexit
referendum. This Brexit hump has now disappeared. This makes put
(spreads) attractively priced compared to one month ago.

This report has been prepared by UBS Switzerland AG. Please see important disclaimers and disclosures at the end of the document.

Volatility

Volatility radar
USA

United Kingdom

S&P 500

FTSE 100

3M

Eurozone

HongKong

SX5E

Hang Seng
3M

3M

Japan

Nikkei 225
1M

Korea

Kospi 200
1M

3M

Volatility

Skew

Tenor

Expensive

Steep

Expensive

Average

Moderate

Cheap

Cheap

Flat

Source: UBS, as of 30 March 2016

Summary
According to most metrics, volatility in the US has decreased and is near the lows of this year. The shorter-dated implied volatility
in particular has decreased significantly and the term structure is again sloping upward. Skew has flattened and is moderate. In
other words, put volatility is fairly priced relative to call volatility.
In the Eurozone, volatility has decreased and is cheap. While at-the-money volatilities have dropped, the skew stayed steep. Euro
Stoxx 50 put volatility is expensive relative to call volatility. Short-dated volatilities have decreased in excess of long-dated volatilities.
As a consequence, the term structure is flat.
Volatility is cheap in Hong Kong/China, with the short-dated volatility tenors cheapening more than longer-dated tenors. At the
moment, put volatility is moderate relative to historical call volatility.
In the UK, volatility has decreased and is currently moderate. One month ago, the term structure showed an unusual hump at the
six-month tenor, reflecting investors' anxiety in advance of the Brexit referendum. This Brexit hump has now disappeared. The FTSE
100 put volatility is expensive relative to call volatility.
Volatility has cheapened in Japan with the short-dated volatility tenors cheapening more than longer-dated tenors. The three-month
implied volatility declined from its February highs and is currently around the one-year average (see Fig. 14). At the moment, put
volatility is moderate relative to historical call volatility.
Volatility is cheap in South Korea, with the short-dated volatility tenors cheapening more than longer-dated tenors. At the moment,
put volatility is expensive relative to historical call volatility.

UBS CIO WM 4 April 2016

Volatility

US

Fig. 1: S&P 500 volatility at YTD lows

S&P 500 three-month implied volatility compared to one-year average

According to most metrics, volatility in the US has decreased and is near

the lows of this year. The shorter-dated implied volatility in particular has
decreased significantly and the term structure is again sloping upward.
Skew has flattened and is moderate. In other words, put volatility is fairly
priced relative to call volatility.
Is market-implied volatility cheap or expensive?
Implied volatility is well below its one-year average, and currently at the
year-to-date lows. In other words, it is cheap. This assessment is based on:
Current three-month market-implied volatility relative to historical
levels. It is below the one-year average (see Fig.1) and in the 29th percentile relative to a one-year period.
Which tenors are the most (or least) interesting?
Short-dated implied volatility has decreased more than long-dated volatility.
As a result, the term structure is steeply upward sloping (see Fig. 2). The
difference between the three-month and the 12-month implied volatility
is in the 70th percentile relative to a one-year period. Therefore, the threemonth volatility tenor is the most interesting long.

Source: Bloomberg, UBS, as of 30 March 2016

Fig. 2: Short-dated tenors are cheap

S&P 500 implied volatility for various tenors (%)

Are put options over- or underpriced relative to call options?

Put volatility relative to call volatility has declined and the skew is moderate
it is in the 41th percentile (see Fig. 3). Concluding, put volatility is neither
over- nor underpriced compared to call volatility.

Source: Bloomberg, UBS, as of 30 March 2016

Fig. 3: S&P 500 skew is moderate

S&P 500 three-month 90% implied volatility minus three-month 110%
implied volatility (%)

Source: Bloomberg, UBS, as of 30 March 2016

UBS CIO WM 4 April 2016

Volatility

Eurozone
In the Eurozone, volatility has decreased and is cheap. While at-the-money
volatilities have dropped, the skew stayed steep. Euro Stoxx 50 put volatility
is expensive relative to call volatility. Short-dated volatilities have decreased
in excess of long-dated volatilities. As a consequence, the term structure
is flat.
Is market-implied volatility cheap or expensive?
Implied volatility is cheap. This assessment is based on:
Current three-month market-implied volatility relative to historical
levels. It is in the 25th percentile relative to a one-year period (see Fig. 4).

Fig. 4: Eurozone volatility is cheap

Three-month implied volatility (%), percentiles relative to a one-year
window

Source: Bloomberg, UBS, as of 30 March 2016

Fig. 5: Short-dated volatility tenors are

expensive
Euro Stoxx 50 implied volatilities for various tenors (%)

Which tenors are the most (or least) interesting?

Shorter-dated volatility tenors cheapened in excess of longer-dated tenors
(see Fig. 5). However, the flat term structure shape still suggests that buying
short-dated volatility could be an attractive strategy.
Are put options over- or underpriced relative to call options?
Euro Stoxx 50 skew is steep, and put volatility is expensive relative to call
volatility for the Euro Stoxx 50. The difference between put and call option
volatility is above the 90th percentile relative to a one-year period. This holds
for all tenors (see Fig. 6).
One way of benefiting from the combination of low at-the-money volatilities and a steep skew is buying cheap put spreads. They can lock in some
of the profits after the market recovery from the February lows.

Source: Bloomberg, UBS, as of 30 March 2016

Fig. 6: Steep skew across all tenors

LHS Normalized skew three-month 90% implied volatility minus threemonth 110% implied volatility divided by ATM volatility for Euro Stoxx
50 for various tenors. RHS Percentile for normalized skew (%).

Source: Bloomberg, UBS, as of 30 March 2016

UBS CIO WM 4 April 2016

Volatility

Hong Kong

Fig. 7: Implied volatility is cheap

Hang Seng Index three-month implied volatility (%)

Volatility is cheap in Hong Kong/China, with the short-dated volatility tenors

cheapening more than longer-dated tenors. At the moment, put volatility
is moderate relative to historical call volatility.
Is market-implied volatility cheap or expensive?
Volatility is cheap. This assessment is based on:
Current three-month market-implied volatility relative to historical
levels. For the Hang Seng Index, it is in the 19th percentile relative to
a one-year period (see Fig. 7).

Source: Bloomberg, UBS, as of 30 March 2016

Fig. 8: Short-dated volatilities cheapened

Hang Seng implied volatility for various tenors (%)

Which tenors are the most (or least) interesting?

While all tenors have cheapened, the short-dated tenors have cheapened
in excess of the longer-dated volatility tenors (see Fig. 8). The inverted term
structure from one month ago has now normalized and is again upward
sloping.
Are put options over- or underpriced relative to call options?
On the Hang Seng Index, put volatility relative to call volatility is moderate
on a historical basis. The three-month volatility difference between put and
call options is near its one-year average (see Fig. 9). To be more precise, it
is in the 65th percentile relative to a one-year window.

Source: Bloomberg, UBS, as of 30 March 2016

Fig. 9: Hang Seng Enterprise Index put

volatility is moderate relative to call volatility
Historical distribution of three-month 90% implied volatility minus threemonth 110% implied volatility, Hang Seng Enterprise Index (%)

Source: Bloomberg, UBS, as of 30 March 2016

UBS CIO WM 4 April 2016

Volatility

United Kingdom
In the UK, volatility has decreased and is currently moderate. One month
ago, the term structure showed an unusual hump at the six-month tenor,
reflecting investors' anxiety in advance of the Brexit referendum. This Brexit
hump has now disappeared. The FTSE 100 put volatility is expensive relative
to call volatility.

Fig. 10: Brexit risk vs protection cost

Chart based on Brexit risk score (see Global risk radar publication) and
protection cost score.

Is market-implied volatility cheap or expensive?

Implied volatility is average, especially the six-month tenor. This assessment
is based on:
Current six-month market-implied volatility relative to historical levels.
It is in the 66th percentile relative to a one-year period (see Fig. 11). One
month ago, it was in the 89th percentile relative to a one-year window.
Source: Bloomberg, UBS, as of 30 March 2016

Source: Bloomberg, UBS, as of 30 March 2016

Fig. 12: Brexit hump disappeared

FTSE 100 implied volatility for various tenors (%)

Source: Bloomberg, UBS, as of 30 March 2016

Fig. 13: FTSE 100 skew is high

FTSE 100 box plot of three-month 90% implied volatility minus three-

8.5

month 110% implied volatility (%).

7.0

7.5

8.0

92nd percentile

6.5

Brexit risk versus cost of protection

Fig. 10 combines all of the above with the fact that Brexit risk has increased.
For more information on the Brexit risk score, please refer to the "Global
risk radar" publication of 18 March 2016. We have an increase in the risk
whereas the cost of protection has declined. This suggest that buying outright puts on FTSE 100 might be attractive.

FTSE 100 six-month implied volatility (%)

6.0

Are put options over- or underpriced relative to call options?

FTSE 100 skew has steepened put volatility is expensive relative to call
volatility (see Fig. 13). The three-month volatility difference between put
and call options is at the 92nd percentile relative to a one-year period. The
steep skew in combination with lowered at-the-money volatility makes put
spreads interesting.

Fig. 11: Implied volatility decreased

5.5

Which tenors are the most (or least) interesting?

Tenors between three and six months have cheapened considerably over
the last month. One month ago, the term structure had at the six-month
tenor a reflection of investor anxiety before the referendum. This Brexit
hump has disappeared, making puts on FTSE 100 cheap compared to onemonth prior (see Fig. 12)

FTSE 100

Source: Bloomberg, UBS, as of 30 March 2016

UBS CIO WM 4 April 2016

Volatility

Japan

Fig. 14: Implied volatility is average

Time series of Nikkei 225 three-month implied volatility (%)

Volatility has cheapened in Japan, with the short-dated volatility tenors

cheapening more than longer-dated tenors. The three-month implied
volatility declined from its February highs and is currently around the oneyear average (see Fig. 14). At the moment, put volatility is moderate relative
to historical call volatility.
Is market-implied volatility cheap or expensive?
Volatility is average. This assessment is based on:
Current three-month market-implied volatility relative to historical
levels. For the Nikkei 225, it is in the 58th percentile relative to a oneyear period.
Source: Bloomberg, UBS, as of 30 March 2016

Which tenors are the most (or least) interesting?

While all tenors have cheapened, the short-dated tenors have cheapened in
excess of the longer-dated volatility tenors (see Fig. 15). The inverted term
structure from one month ago has now normalized and is again upward
sloping. Given that the term structure has normalized, no particular tenor
stands out.

Fig. 15: Short-dated volatilities cheapened

Nikkei 225 implied volatility for various tenors (%)

Are put options over- or underpriced relative to call options?

On the Nikkei 225 Index, put volatility relative to call volatility is moderate
on a historical basis. The three-month volatility difference between put and
call options is near its one-year average (see Fig. 16). To be more precise, it
is in the 58th percentile relative to a one-year window.

Source: Bloomberg, UBS, as of 30 March 2016

Fig. 16: Nikkei 225 has a moderate skew

Historical distribution of three-month 90% implied volatility minus three-

10

month 110% implied volatility, Nikkei 225 (%)

58th percentile

Nikkei 225

Source: Bloomberg, UBS, as of 30 March 2016

UBS CIO WM 4 April 2016

Volatility

Korea

Fig. 17: Implied volatility is cheap

Kospi 200 three-month implied volatility (%)

Volatility is cheap in Korea, with the short-dated volatility tenors cheapening more than longer-dated tenors. At the moment, put volatility is
expensive relative to historical call volatility.
Is market-implied volatility cheap or expensive?
Volatility is cheap. This assessment is based on:
Current three-month market-implied volatility relative to historical
levels. For the Kospi 200, it is in the 23rd percentile relative to a oneyear period (see Fig. 17).
Which tenors are the most (or least) interesting?
While all tenors have cheapened, the short-dated tenors have cheapened
in excess of the longer-dated volatility tenors (see Fig. 18). The three-month
tenor in particular is cheap.

Source: Bloomberg, UBS, as of 30 March 2016

Fig. 18: Short-dated volatilities cheapened

Kospi 200 implied volatility for various tenors (%)

Are put options over- or underpriced relative to call options?

On the Kospi 200 Index, put volatility relative to call volatility is expensive
on a historical basis. The three-month volatility difference between put and
call options is in the 74th percentile relative to a one-year window.

Source: Bloomberg, UBS, as of 30 March 2016

Fig. 19: Kospi 200 skew is steep

Historical distribution of three-month 90% implied volatility minus three-

10

12

month 110% implied volatility, Kospi 200 (%)

-2

74th percentile

Kospi 200

Source: Bloomberg, UBS, as of 30 March 2016

UBS CIO WM 4 April 2016

Volatility

Eurozone sectors

Fig. 20: Bank volatilities are expensive

Percentiles of implied volatility relative to one-year history (%)

Which sector is the most interesting?

Within the Eurozone sector indices, the Euro Stoxx Banks index (SX7E) is the
most interesting. The implied volatility for SX7E is high for all expiry tenors
(see Fig. 20) the implied volatilities are all at a high percentile relative to
their respective one-year historical distribution.
The Euro Stoxx Banks index combines the high at-the-money implied volatilities with a steep skew (see Fig.21). Its three-month 90%-110% skew is at
the 99th percentile relative to a one-year window.
Finally, UBS CIO has an overweight on the Eurozone financials sector. See
"UBS Equity Compass" of April 2016 for more details. Combined, this
makes SX7E a good candidate to sell volatility on.

Source: Bloomberg, UBS, as of 30 March 2016

Fig. 21: Short-dated volatilities cheapened

Sector 90% implied volatility minus three-month 110% implied volatility
(%) and their percentiles

Source: Bloomberg, UBS, as of 30 March 2016

UBS CIO WM 4 April 2016

Volatility

Data
Implied volatility at-the-money three-month tenor
Implied volatility (%)

Source: Bloomberg, UBS, as of 30 March 2016

Skew 90%-110%, three-month tenor

Skew (%)

Source: Bloomberg, UBS, as of 30 March 2016

UBS CIO WM 4 April 2016

10

Volatility

Jargon Buster
Realized volatility
Realized volatility measures how volatile an asset was in the past. Though
calculation methodologies vary slightly in the number and frequency of
observations, it is best defined as the standard deviation of price returns
over a given period. Most commonly, this figure is then annualized to
enable comparison with other time periods.

Fig. 13: Example of box plot use

Schematic overview of the distribution

Implied volatility
Implied volatility is the best estimate the market has for future realized
volatility. It is a critical component of the industry standard Black Scholes
option pricing formula. The best estimate of the future realized volatility
(implied volatility) is often closely related to the observed realized volatility.
In our forthcoming publication, "Volatility 101," these concepts will be discussed in greater detail.

Source: UBS, as of 2 March 2016

Box plots
A box plot is a convenient way to graphically depict the key characteristics
of a distribution. It consists of a body that shows the 25th, median, and
75th percentiles. The whiskers show the maximum and minimum observed
value. Furthermore, the box plot shows the current observation in relation
to the historic distribution (see Fig. 10).
In Fig. 10, the minimum observation is approximately 9 and the maximum
observation is approximately 14. Further, 25% of the observations are
below 10.5, 50% of the observations are below 11.1, and 75% of the
observations are below 11.7.
In the example, the current observation is approximately 13, and 97% of
all data observations are less than the current observation.

UBS CIO WM 4 April 2016

11

Volatility

Appendix

Terms and Abbreviations

Term / Abbreviation

Description / Definition

Term / Abbreviation

Description / Definition

A
p.a.
Shares o/s

actual i.e. 2010A

Per annum (per year)
Shares outstanding

COM
R and D
UP

CIO

UBS WM Chief Investment Office

YTD

Common shares
Research and development
Underperform: The stock is expected to
underperform the sector benchmark
Year-to-date

UBS CIO WM 4 April 2016

12

Volatility

Appendix
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Appendix
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