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Highly accommodative monetary policy and the increased
responsiveness of central banks globally to economic shocks and other crises
has led to a situation where, if such a shock occurs, then central banks ease
monetary policy quickly in response. This action calms markets,
resulting in minimized selloffs and contained volatility while driving
equities higher.
This phenomenon can be described as the Central Bank Put
Option, as the situation effectively means that investors have a put option
given to them by the central banks. We will discuss its origin and how it is
currently in play, and then cover different strategies that can be used to
take advantage of the put. Following this we will also look to analyse
whether the Central Bank Put will be in play next year and how it may be
traded going forward.
The Bernanke Put
The term “Greenspan Put” was first coined in 1987 to
describe the situation of then Fed Chair Alan Greenspan adding monetary
liquidity to avert a further deterioration of the markets after the 1987
crash, and throughout his term as Fed Chair. With Ben Bernanke taking over as
Fed Chair in 2006, the term “Bernanke Put” became widely used as the Fed
continued the practice of lowering rates to counter falling markets.
Following the GFC and during the Great Recession the Fed took on a highly
dovish stance, cutting interest rates repeatedly and engaging in monetary
easing on a massive scale. This has resulted in a massive bull market in
equities, with the periods of greatest strength coming during periods of
increased dovish activity by the Fed.
Less than three months into QE1 the stock market ceased its decline,
following which the S&P rallied more than 70%. The next round of easing
lasted only six months, but QE2 nonetheless saw the S&P push a solid 15%
higher. During Operation Twist markets rallied again, this time by more than
a quarter. Throughout its span QE3 saw the S&P rally another 40%.
It is important also to consider the movement in stocks in between these
gains. The most telling of these is the weeks between QE2 and Operation
Twist. This gap saw markets decline considerably, erasing the gains made
during QE2 and threatening to move lower. Thus we have a situation of markets
falling without new action from the Fed and the Fed responding with further
easing that drove markets higher again.
Therefore, investors could speculate on the stock market without the fear
of a crisis negatively affecting their portfolio’s, as the Fed would quickly
intervene with new easing measures to ensure that any selloff was quickly
reversed. This means that if an investor held a long position on equities,
then they had protection from the Fed Chair Bernanke on any downside. Thus,
we have the Bernanke Put.
The Global Central Bank Put
Major central banks, such ECB, BoJ, and BoE to name a few, took highly
accommodative stances on policy following the GFC. The effects on their stock
markets has been much the same as the Fed’s has been on US equities. European
markets can rally knowing that if things go south, the ECB will step in.
Taking this a step further and without loss of generality, we see that
European markets also know that the Fed will take action if the US economy
suffers an economic shock, and vice versa. This means that every stock market
is far less vulnerable to overseas shocks, as a result of foreign action, and
is far less vulnerable to domestic shocks as their own central bank will take
action in that situation.
The chart above shows that during QE1 and QE3 European stocks also rallied
well. During QE2 stocks in Europe did not perform as well, however this was
mirrored to a lesser extent in the S&P and was a result of a lack of
action from the ECB in response to the Greek debt crisis. We will discuss
this risk in further depth below. Now that the ECB has a QE program in place
European stocks rallied well before the concerns around China’s growth
panicked markets. However, these fears are now passing with the People’s Bank
of China taking action. As a result both US and European equities have
rallied back.
Therefore, we have a Global Central Bank Put Option in play, the effect of
which is much stronger than a Bernanke Put due to the spill over of all major
central banks having similar policies in place. The result is that crises
with the potential to harm the global economy can be much better absorbed and
without significant negative effects.
Trading the Global Central Bank Put
The Fed has been moving towards an interest rate hike
this December. However, their overall stance has still been highly
accommodative throughout 2015, as has the stance of central banks globally.
This means that the global central bank put has been in play during 2015. We
have taken advantage of this through a number of strategies, namely by
selling downside protection on equities and selling volatility spikes.
We sold downside protection on equities by shorting in the money put
spreads on SPY, the ETF that tracks the S&P. During February we sold SPY
Dec ’15 $185/$180 vertical put spreads for $1.30. Provided that SPY remained
above $185, or equivalently the S&P above 1850, we could collect the
maximum gain by holding the trade until expiration.
Even with the correction made in August the S&P has not traded as low
as 1850 all year. We chose to tactically exit the position after just
29 days to bank a 13.24% profit, and have used the strategy
regularly since then as a part of our trading arsenal.
We have also made a number of trades selling spikes in volatility, all
of which have been profitable. During the Ebola panic last year the
VIX, the index that tracks S&P 500 volatility, more than doubled when it
spiked to over 30. Given that the Central Bank Put was in play, we knew that
this spike was highly unlikely to last. Either markets would calm of their
own accord, or central banks would take action to ensure that equities
rallied back and that volatility would consequently fall. Accordingly, we
heavily shorted the VIX index by buying XIV, the inverse ETF for the VIX.
We allocated 25% of our portfolio in total, using 5% and 10% clips to
progressively increase our volatility short as the VIX index rose. As markets
calmed and the VIX fell back to normal levels below 12 we took profits on our
short, gaining as much as 18.14% on just one of these
positions.
While the profits banked on these types of trades are less than our
average of 28.41%, they carry highly favourable risk reward dynamics. The
likelihood of a loss is very low as the Central Bank Put greatly increases
the probability that profits can be banked if the trade is set up correctly.
Each of the trades we made have also been with limited risk, so we knew the
maximum losses going into the trade.
Consider the alternatives to these type of trades that also look to take
advantage of the Central Bank Put. One could have sold puts that would expire
worthless if markets remain high. This is similar to our vertical put spread
trades, but involves unlimited risks if markets fall, which we do not believe
is prudent to take on.
The Central Bank Put does not guarantee that markets will rally, but
rather protects against the downside. This means that upside directional
plays, such as buying calls or stocks outright, are not ideal to take
advantage of the Central Bank Put. These type of trades have their place and
we regularly use them, but for simply making money on the Central Bank Put
they are not ideally suited.
The Road Ahead
Monetary policy the world over remains highly accommodative. This is
likely to remain the case in next year, even if the Fed hikes in December as
we believe they will. However, does this mean that the Central Bank Put will
still be in play in 2016?
Quantitative easing now has had diminished benefits. Broad based programs
similar to QE1 and QE2 are unlikely to be effective enough to keep the
Central Bank Put active. This means that more targeted measures, such as
buying credit, will be necessary to ensure markets are confident that central
bank action is sufficient maintain economic health, and thus keep markets
from falling.
This means that the Central Bank Put is unlikely to be in play for markets
where their respective central bankers are not able to effectively, and
swiftly, evolve and advance easing methods when required. The value of the
Central Bank Put is inextricably linked to the credibility of the
policymakers that are targeting asset price stability. Therefore any
announcements of new QE programs need to be analysed carefully if one intends
to make a trade to take advantage of this Central Bank Put.
While the Central Bank Put offers many trading opportunities, there is no
such thing as a free lunch. These opportunities must be treated with caution.
If markets react negatively to a new, or even existing, measure, the downside
risks to Central Bank Put based trades are substantial.
Consider the Greek debt crisis of 2010 when the ECB failed to act quickly with
the necessary measures to calm markets. The result was that by the time the
ECB announced a bailout plan fears had already set in. Markets did not have
the confidence that the central bank intervention was enough when it came
into play, and as a result the EuroStoxx 50 index decline more than 10% even
after the bailout plan was released.
European equities therefore declined more than 17% from peak to bottom
before beginning to sluggishly move higher again, finishing around 5% down on
the year despite central bank action. This situation demonstrates the risks
involved with taking advantage of the Central Bank Put. Had one tried to do
so with European stocks in 2010 they would have very likely lost money. Any
outright long trade would have finished lower on the year while an options
based trade would have potentially lost considerably more.
While at present the chance of this kind of downside being realised is
small, the diminishing effect of various QE programs and a shift towards
tightening in the US mean that these low probabilities have the potential to
grow significantly.
Therefore there is no definitive yes or no answer to our question of
whether the Central Bank Put will be in play in 2016. We believe it is likely
that there will still be trades that can benefit directly from the Central
Bank Put next year, however the nature of these positions will very likely
vary. Therefore, as with all trading strategies that we employ, we will
continually examine and re-examine the risk reward dynamics involved.
We believe that this will allow us to find and take
advantage of those opportunities and, more importantly, avoid those trades
that will be likely to lose money. If you wish to find out the results of
this analysis throughout the changing market dynamics the next year will
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