Volatility Knock-Out Options are Back in Demand
After the invasion of Iran by the United States and Israel on February 28th this year, the conflict has introduced high energy shocks and what some commentators might suggest as political disinformation, which has produced geopolitical upheaval resulting in financial markets becoming extremely volatile. Increased uncertainty has boosted demand for risk-management tools, specifically volatility driven instruments, hence the return of “Volatility Knock-out Options”.
Volatility Knock-Out Options or VKOs as they are usually referred to, are specialised cost-effective derivative instruments, typically “Put-Options”*, that become void if the underlying asset’s realized volatility exceeds a predetermined level during the life of the option. They are designed for “Buy and Hold” hedgers seeking lower premiums, cutting costs by up to 40% compared to standard vanilla puts exploiting the steepness of implied volatility skew**.
*Put Option – This is a financial contract giving the holder the right but not the obligation to sell an underlying asset (e.g., equities, commodities, currencies) at a set price, (the Strike Price) within a specific timeframe. It acts as a bearish bet or insurance increasing in value as the underlying asset’s price falls.
**Volatility Skew – Indicates variations in implied volatility across options, revealing insights into expectations and market sentiment. To develop effective trading and in order to price options, skew patterns serve as a valuable tool in this market. An important ingredient is that the skew reflects differences between implied volatility across options with different strike prices, but with same expiry dates, therefore highlighting market sentiment and expectations.
Earlier this year, markets were relatively calm, and in January, the FTSE 100 hit a record high with implied volatility at circa 50% of the current level. However, since then, implied volatility has climbed above 23%, forcing institutions to switch from expensive vanilla puts to VKOs in order to manage hedging costs. In essence, VKO adoption is usually higher than 23%, more often than not around a realised volatility threshold of 30%, and in particular in the context of the S&P 500 (SPX) hedging.
Overall, the renewed interest, especially institutional interest in VKOs, is down to the Middle East crisis and the ensuing volatility that has been engendered. Participants have turned to this option as it is cheaper than standard vanilla puts. The VKO features a realised volatility barrier that makes the option expire worthless if the market becomes too volatile, which eliminates the premium costs associated with volatility.
