The UK elections and volatility
09 April 2010
The UK elections and volatility
With volatility across all asset classes globally at or near recent lows the question is: where is volatility going now? Normally, an options trader uses low volatility to build up long positions ( going ‘long premium’) in the options market as increasing volatility drags up option prices. However, since the start of 2010 options traders who have used any sell-off in volatility to buy options have lost out in most cases as volatility has just fallen further.
With this week’s announcement that the UK general election will take place on 6th May, I would like to take a closer look as to what might be the consequences of the markets of various situations and outcomes on volatility and therefore on option prices.
To start off, I have included three diagrams of historical implied volatility on both the FTSE100, the 10 – Year Gilt future and historical 30 day volatility for the GBP/USD exchange rate. In all cases it is clear that volatility has fallen quite significantly and remains historically low. Although GBP/USD has risen in recent times, it is still low in the historical context.
How will the UK election affect volatility among these asset classes: equity, bond and currency?
There are two possible outcomes: one party will have a clear victory or no clear victory leading to a hung parliament.
In the case of one party achieving a clear victory we would not expect a big move in volatility as it will take time for the new government to formulate and introduce any new economic policy.
However, if there is a hung parliament it is quite likely that volatility will increase quickly. The reason for this is simply that the UK is not used to hung parliaments or coalition governments and this will therefore increase uncertainty.
Also, volatility is quite likely to increase in the time leading up to polling day as various different opinion polls show different outcomes. The closer the parties are tied the more the increase can be expected.
However, as we all know the only true and real opinion poll is the actual vote. Therefore, we can turn to the old saying “buy the rumour and sell the fact”. This implies it may well make sense to buy options at this early stage of the campaign and then sell the options when the result comes in at which stage the market will probably start discounting the reality of the new government however, it may turn out to be and UK markets will return to normal.
In the coming days Seven Days Ahead will looking for any opportunities to use to go long volatility in the UK market.
Of the three asset classes we prefer the Gilt market. The reason why the Gilt market will most likely see the biggest move is two-fold.
Firstly currently bonds are already at high levels in terms of price (low yields) therefore a sell off is quite possible.
Secondly, no matter what type of government takes over after the election, one of their biggest priorities is going to have to be tackling the public deficit. This may well add further to Gilt issuance which will have the affect of forcing yields higher (prices lower) over time. This therefore makes
Gilts are a good candidate for a long options strategy.
The main reason why we choose not to focus on the FTSE in the current environment is the fact that the FTSE is an extremely internationally-focused equity index. If we look at some of the largest holdings in the index such as Shell, BP, Rio Tinto and BHP for example they all have very little to do with the domestic UK economy.
Mark Ridgeway
Seven Days Ahead
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