Equity Equity Equity

Equity correction and tail-hedging with market makers

Equities 10 minutes to read
PG
Peter Garnry

Head of Equity Strategy

Summary:  The front end of the VIX futures curve is still in contango and thus the equity market has not yet entered a real correction although down 5% from the peak. If the global energy crunch gets worse investors should be prepared for a 10-20% correction. In today's equity note we also extend our previous analysis of using market makers for tail-hedging showing that Virtu and Flow Traders have little correlation to global equities and can preserve capital during the 1% worst daily returns in the MSCI World.


German baseload electricity 1-year forward prices are up another 15% this week ending the increase to 320% since the world learned about the successful mRNA vaccines early November. We are currently undergoing a historic global energy crunch with Europe and China being hit the hardest. In addition wage growth among low-income workers has approached the highest levels in many decades. In many countries there are a shortage of workers and interest are now also responding to the energy crunch. Everywhere we look companies’ profitability is under pressure from rising input costs across the whole cost structure. This will be the overreaching theme in the upcoming Q3 earnings season.

Source: Bloomberg
Source: Bloomberg

The MSCI World was down 1% yesterday extending the drawdown to 5.5% which naturally attracts the ‘buy-the-dip’ flow betting on a quick reversal as we have seen so many times. But is this time different? The current energy crunch and rising commodity prices is the worst since the energy crises of 1973 and 1979, and will have profound impact on companies, households, and inflation. In our view risks are skewed to the downside in equities and the correction has not even remotely exhausted itself. The VIX futures spread between the two nearest contracts measures the curvature of the first part of the volatility curve on equities and the spread is currently only 3%. In other words, the VIX futures curve is still in contango. During more profound corrections, the curve flips into backwardation with -20% being the level for a mild correction and more than -40% for severe corrections. Given the current VIX futures curve there is plenty of downside risks should power prices continue to increase.

Puts, futures, or market makers?

In our August research note Tail-hedging with market makers we argued that publicly-listed market makers such as Virtu Financial and Flow Traders have remarkable hedging capabilities because market makers are naturally long volatility. But even more importantly because of a positive drift in volume over time in financial markets these market makers are also experiencing a positive drift in their share price. This means that investors can get tail-hedging without the negative expected returns that are typical of option or VIX strategies. As the correlation matrix below shows these two market makers have zero correlation to the MSCI World and the correlation between them is low. This means that Virtu Financial and Flow Traders possess great diversification contribution to a portfolio and that both should be owned as they are correlated and are capturing different things from the flow.

Source: Bloomberg and Saxo Group

The two market makers went public in 2015 so we only have limited data points but still a couple of equity market corrections to lean on. Using quantile regression techniques we can model the distribution of returns for Virtu and Flow Traders given the percentiles of returns in MSCI World. Since April 2015 the 1%-percentile is -2.8% daily return with the worst daily return being -10.4%; in other words, very fat tails in global equities since 2015. As the histogram below shows, Virtu and Flow Traders have 37% and 56% probabilities for having a positive return during a -2.8% daily return in the MSCI World. The mean expected return for Virtu and Flow Traders is -0.44% and 0.17% respectively indicating the capital preservation capabilities during equity market stress. Both Virtu and Flow Traders have had a positive cumulative return during the current equity market drawdown, and this is even without backwardation in the VIX futures curve and real stress.

Source: Bloomberg and Saxo Group

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-gb/legal/disclaimer/saxo-disclaimer)

Saxo Markets
40 Bank Street, 26th floor
E14 5DA
London
United Kingdom

Support Centre
For existing clients, please click here to request support via the Support Centre.

Have a question about our products, platforms or services? Visit the Support Centre to find answers for our most frequently asked questions. If you are still unable to locate an answer to your question, you will also find contact details for your local Saxo office to speak with a representative.

Contact Saxo

Select region

United Kingdom
United Kingdom

Trade Responsibly
All trading carries risk. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. Read more
Additional Key Information Documents are available in our trading platform.

Saxo Markets is a registered Trading Name of Saxo Capital Markets UK Ltd (‘SCML’). SCML is authorised and regulated by the Financial Conduct Authority, Firm Reference Number 551422. Registered address: 26th Floor, 40 Bank Street, Canary Wharf, London E14 5DA. Company number 7413871.

This website, including the information and materials contained in it, are not directed at, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in the United States, Belgium or any other jurisdiction where such distribution, publication, availability or use would be contrary to applicable law or regulation.

It is important that you understand that with investments, your capital is at risk. Past performance is not a guide to future performance. It is your responsibility to ensure that you make an informed decision about whether or not to invest with us. If you are still unsure if investing is right for you, please seek independent advice. Saxo Markets assumes no liability for any loss sustained from trading in accordance with a recommendation.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc. Android is a trademark of Google Inc.