As volatility rises amid the increasing US-China trade war, investors seeking safety in volatile markets are being smacked with skyrocketing hedging prices. As markets fell earlier this week, downside bets were more costly, but strategists at UBS Group AG and Credit Suisse still see relative possibilities. According to Bloomberg, while the Nasdaq 100’s implied volatility is very inexpensive, investors may still find value in betting against the technology-heavy index by shorting the Invesco QQQ Trust Series 1 (QQQ) exchange-traded fund (ETF).
“We continue to favor the Nasdaq for hedging,” UBS strategist Stuart Kaiser stated. “While equities volatility has been repriced much higher, we believe there is still potential in buying QQQ downside,” said Credit Suisse analyst Mandy Xu.
What It Means for Investors
The Nasdaq 100, a market capitalization-weighted index that measures the top 100 non-financial firms listed on the Nasdaq stock exchange, lost 3.6% on Monday, the most since the beginning of the year. The index’s large tilt toward the technology sector makes it a popular barometer of tech stock performance, and its dip earlier this week occurred as China permitted the yuan to fall in retaliation for Trump’s promise to put extra tariffs on Chinese exports.
“While Trump’s extra tariffs startled markets last week, China’s reaction over the weekend by allowing the yuan to slide over 7 was the game changer,” said Xu, according to Bloomberg.
More Nasdaq 100 falls are inevitable as chances for a near-term trade ceasefire fade. The PowerShares QQQ ETF, which is up 22% year to date and has already seen inflows more than double by early spring this year, not only provides investors with marketable securities that track the Nasdaq 100, but also allows them to hedge against downside risks by betting against the index using stock options, specifically put options.
The implied volatility gap (a measure of the relative cost of buying options) between the Nasdaq 100 and the S&P 500 was close to a year-to-date low earlier this week. Meanwhile, the CBOE Volatility Index (VIX), widely known as the market’s “fear gauge,” jumped 40% to its highest level since January on Monday.
Xu advised investors to utilize a bear option spread on the QQQ to hedge against Nasdaq 100 declines. The owner of a put option has the right, but not the responsibility, to sell the underlying asset. A bear put spread includes purchasing (long) put options on a certain asset while simultaneously selling (short) an equal number of put options with the same expiry date but a lower strike price.
The greatest possible profit of the approach is represented by the difference in strike prices minus the net costs of the options. When the QQQ falls below the strike price of the long put trade, the investor starts to recuperate part of the investment’s cost. Once those expenses have been completely recovered, any further drops represent pure profit until the lower strike price of the short position is breached—any more profits on the long position will be offset by losses on the short position.
While the bear put strategy may help investors to hedge their portfolios against further market declines, the relative value advantage is unlikely to last forever. If the advantage really does exist, options traders looking forarbitrage opportunities will eliminate any perceived gap between options prices and fundamental values. But of course, when uncertainty is high, fundamental values are highly uncertain.
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