Politics Hedges Become Pain Trade for Europe Stock Investors

Updated on
  • Traders pay up for protection, VStoxx contracts volume soars
  • Dutch vote result sends equities up and volatility down

Traders’ choice to hedge against European equity volatility is proving to be a costly one, especially in light of the Dutch vote dealing a blow to the surge of populism in the region.

Investors worried about national elections -- and France’s in particular -- began protecting against stock swings soon after the year started. By February, the cost of VStoxx Index futures maturing around the first round of French voting was surging, a rise that occurred much earlier than the move seen last June just before the British referendum on European Union membership.

Now, volatility bets have eased, and a BNP Paribas SA gauge tracking political risk in the euro area has tumbled to its lowest level since October as of its last reading on Monday. The Liberals’ victory in Wednesday’s Dutch parliamentary election has removed some stress from the market and helped propel the Euro Stoxx 50 Index to its highest level since December 2015. Some analysts view the result as a signal euroskeptic Marine Le Pen’s momentum in France is fading.

“Investors bought very expensive insurance -- there has been a bit of a miscalculation,” said Ken Odeluga, a market analyst at City Index in London who also covers derivatives. “The degree of calm in equity volatility we are seeing may point to the chances of further anti-establishment disruption being very, very low. There was more panic earlier in the year that’s now moderated due to developments among the French presidential candidates and election results elsewhere in Europe.”

While opinion polls point to Le Pen winning the first round of elections on April 23, they predict she will lose the May runoff by a wide margin against either Emmanuel Macron or Francois Fillon.

Despite the spread between the April and May VStoxx futures narrowing, hedging prices aren’t at bargain levels. Generic two-month contracts remain at a record high relative to one-month bets. Investors scrambling for protection have pushed the number of options and futures outstanding on the volatility gauge to all-time peaks, trading them like never before in February. JPMorgan Chase & Co. estimated in a note two weeks ago that European equities could move around 6 percent following the ballot.

“Investors are positioning earlier into this event than previous events -- the cost of protection is still higher than average,” said Cathal Hardiman, a derivatives sales trader at Susquehanna International Securities based in Dublin. “The trading flow has been quite orderly: Investors have been buying more protection when Le Pen’s probability increases and backing off when it decreases.”

Investors concerned about the vote’s impact have had plenty of recommendations to choose from to protect against stock volatility. Here are some that were published in recent weeks:

  • BNP Paribas SA suggested shorting VStoxx April puts while buying June contracts.
  • JPMorgan said the DAX Index would probably outperform in an adverse scenario and recommended a put switch between the German gauge and the Euro Stoxx 50. 
  • Societe Generale SA recommended a Euro Stoxx 50 put structure taking into consideration that the euro may come under pressure.
  • Bank of America Merrill Lynch advised selling S&P 500 Index straddles expiring on April 21, before the first election round, to partly finance same-strike straddles expiring April 28. Globally, short-term options on Korea’s Kospi 200 Index offer the best value, the firm said, recommending strangles or calls.
  • Macro Risk Advisors has suggested options and futures strategies on the CBOE Volatility Index.
  • Back in January, Louis Capital Markets advised to prepare for a slump in European equity volatility after the vote, recommending VStoxx May 21 puts.
(Updates with second quote, BNP Paribas’s recommendation.)
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