EQDerivatives: "Opportunities Remain As European Elections Drive VSTOXX Flow"

The uncertainty surrounding populist parties across Europe has been creeping into equity markets over the last few months, with elevated levels spotted in the term structure of the Euro Stoxx 50 Volatility Index, as investors position around the upcoming elections. Although levels in the VSTOXX have subsided following Prime Minister Mark Rutte’s victory in the Dutch election, opportunities still remain as the French election grows nearer. Georgia Reynolds reports on flow and positioning trends in Europe’s benchmark volatility index.

It is often said that 20th century Italian fascist dictator Benito Mussolini was the first Italian leader to get the trains to run on time. While this is likely just a propaganda-stoked myth, even if it is true, the economic benefits of a punctual train service are likely countered by the destruction rampant nationalism inflicted on Europe during World War Two. The other thing to remember about European fascists, is that power is usually given to them freely. King Victor Emmanuel III, for instance, invited Mussolini to form a coalition government, while Ioannis Metaxas, then minister of war, was appointed interim prime minister by George II in 1936, with the Greek parliament confirming the appointment later on. Both constitutionally appointed fascists soon showed their true strongman tendencies soon after.

In today’s Europe, the hard right is at it again and investors seem to be taking note of history while positioning for the future. The National Front Party’s Presidential Candidate Marine Le Pen has been driving the polls recently, proving that political events are correlating firmly with equity volatility, as investors fret over the potential consequences of the right’s reemergence. Like other European far-right populists, Le Pen is running on an anti-E.U. platform, leading many commentators to brand the upcoming April 23 election “Frexit.” Should no candidate win a majority in April, a run-off election between the top two candidates will be held the following month on May 7. Recent opinion polls suggest that centrist candidate Emmanuel Macron is neck-and-neck with Le Pen in the first round.

A National Front victory has the potential to cause a drop in equity markets, according to strategists. The expensiveness of the April VSTOXX futures/ May EuroStoxx 50 volatility illustrates the outstanding long volatility positioning of the market. Strategists suggest it is therefore likely that, should Le Pen be elected, volatility would underperform the move of equity markets, amid a flurry of volatility sellers trying to take profit on their prepositioning. However, if Le Pen does not win the election, they predict short-term volatility should decline substantially and the euro should see a slight increase.

The election is seen an uncertain event, playing a pivotal role in the current European financial landscape, due to the possible outcomes bringing about widely different market reactions. Given the large positioning on SX5E post-election volatility, strategists at Societe Generale note that the upside on volatility may underperform downside on spot if Le Pen were to win the election. In a recent client note, they recommend hedging via low-cost options such as a SX5E put conditional to EUR/USD lower or via VSTOXX options strategies that they say would make money in either direction.

Meanwhile, France’s CAC 40 index has continued to significantly underperform Germany’s DAX since the start of the year. Yields on short-term German bonds hit record lows on March 3, as investors moved to protect themselves against the possibility of a National Front victory. While German bond yields hitting lows reflects positive news for the domestic economy, it is reported that Merkel’s support of the E.U. is being questioned by investors.

Over in the U.S., the French election has so far had little impact on the CBOE Volatility Index term structure, unlike the VSTOXX, with expectations that U.S. volatility parameters will likely react to the election as the poll date gets closer. In a bid to play the expected volatility around the presidential election, relative value traders are looking at VIX futures butterflies, selling the March future, buying two April futures and selling one May future. Volatility managers are trading option calendar spreads with fixed downside, such as call spreads vs. calls in order to gain exposure to the growing kink seen in the futures market, but with controlled downside.The VSTOXX futures term structure, meanwhile, is steep, with April being particularly elevated.

Strategists at Barclays said the April VSTOXX future will likely retain the election bump. “We consider the April levels still high enough in absolute terms to engage in the monetizing the steep VSTOXX term structure with VSTOXX April 17 puts,” said Christian Kober, strategist at Barclays in London, in early March. “Investors can also combine such a carry position with the hybrid put option hedge, which should work well if the elections do not cause a risk-off event, as the volatility put will finance the premium outlay, and if they do cause a volatility spike, as the loss of the volatility put is capped to the premium while the hybrid put option should generate a high payoff.”

Gabriel Manceau, VSTOXX trader at Morgan Stanley in London, explained that since the beginning of the year he has seen a variety of VSTOXX trades and VSTOXX futures spread trades, specifically in April and May expiries around the French election. “The April future is going to contain the implied move and the May is going to be the future that moves after the French election,” he said.

One recent profitable strategy in the VSTOXX has seen investors buying a put calendar with the expectation that implied volatility will remain high before the French election. This is done through buying May puts in VSTOXX, financed by selling April downside puts. “This is the trade I have seen that was the most successful,” Manceau said. However, the trade that he has seen executed the most is naked positioning in VSTOXX April futures to play the implied volatility shift in Europe.

Since the beginning of the year more than two million futures have been traded on the VSTOXX, with options usage also seeing a sharp spike, according to Eurex. The options have now broken their open interest record with more than one million contracts, a positive sign for the asset class, which has struggled with liquidity since it launched. The bourse recently opened the market for all U.S. participants that want to trade the VSTOXX, so that they have direct market access. Bringing the VSTOXX to U.S. investors has also increased the current number of investors participating in the VSTOXX market.

Another popular strategy has involved investors selling April-17 downside puts in the VSTOXX and buying the May-17 call. “This trade is when [investors] buy a bad outcome on the French election by buying a May call and you finance that by selling the downside puts,” Manceau said. So far in March, there has been a shift in sentiment as investors take profits on the positions as Macron catches up with Le Pen in the polls.

Relative value traders also looked at selling the March future, buying two April futures and selling one May future, in a bid to play expected volatility around the French presidential election. JPMorgan noted that relative value is interesting as it is off the highs in terms of the spread.

Elsewhere, the kink around the VSTOXX April expiry has opened V2X/VIX call spread trades. The growing disparity between the term structures around the election in April is increasing and could accelerate, opening up option spread opportunities. The spread reflects the different risk embedded in the two regions. Therefore, it is difficult to either go long or short at this level, according to strategists. The VIX term structure is seemingly unaffected by the election, but strategists in the U.S. predict it will likely react to the election as the date gets closer, similar to what was seen last year in the lead up to the Brexit referendum and the U.S. election.

However, in the wake of the Dutch election, the probability of Le Pen being elected has decreased by 4-5%. Consequently, VSTOXX has lowered, especially the April contract, down by 1.5pts within a few days, according to Hervé Guyon, equity derivatives flow strategy and solutions at Societe Generale in London. “Investors saw this as an opportunity to reload on June 2017 calls on SX5E conditional on April VSTOXX contract remaining above a barrier,” Guyon said. He added this trade has performed positively since the beginning of the year as SX5E and the April VSTOXX contract has de-correlated.

Indeed, hedging from investors on SX5E options maintained the VSTOXX April contract at elevated levels despite SX5E positive performance. “This retracement is also a new opportunity to hedge the election risk,” Guyon explained. “Selling puts on VSTOXX April contract, in order to finance upside call spreads on May VSTOXX contract, is back at interesting levels.”

Georgia Reynolds is a reporter at EMEA at EQDerivatives, based in London. A recent graduate from City University London, Georgia has been studying and producing print and multimedia journalism for five years.