How Rising Rates Could Drastically Change the Trading Environment

How Rising Rates Could Drastically Change the Trading Environment

Posted On May 4, 2022 2:11 pm

Stocks are broadly lower as investors await the Fed’s announcement on interest rates and monetary policy.  It’s expected to raise rates by 50 basis points, begin shrinking the balance sheet and plan an aggressive future rate hike path to combat inflation.

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Yesterday I discussed how to profit from harnessing implied volatility where I hinted that interest rates, which are one of the 5 inputs that make up the Black-Scholes model of option pricing, were going to become increasingly important. 

Today, I want to look at how this dramatic policy shift, not seen since the late 1970s, could drastically shift the trading environment and lead to an extended higher volatility period and a bear market continuation. 

 In his paper, Volatility and the Alchemy of Risk, Artemis Capital’s Christopher Cole wrote, “Volatility fires almost always begin in the debt markets… 

Volatility is the brother of credit… and volatility regime shifts are driven by the credit cycle.” 

“When times are good and credit is easy, a company can rely on the extension of cheap debt to support its operations. Cheap credit makes the value of equity less volatile, hence a tightening of credit conditions (rising interest rates) will lead to higher equity volatility.” “The IMF warns that 22% of U.S. corporations are at risk of default if interest rates rise. Median net debt across S&P 500 firms is close to a historic high at over 1.5x earnings, and interest coverage ratios have fallen sharply.” 

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He provides this nice image of how the credit cycle, hedging, and buybacks all work toward creating an illusion or alchemy of risk mitigation. But, in fact, is a self-destruction act, ultimately turning on itself.  

It’s interesting to note that Cole doesn’t regard volatility as a reflection of changing market conditions. 

Given that many of the volatility gauges and trading products are options-based, and in turn, interest rates are one of the option value inputs, it’s easy to understand how rate rises can create a circular volatility increase.  We saw a case of the ‘tail wagging the dog” in early February.  

 If the Fed gets as aggressive as some people think we could see an extended period of volatility. Which should translate into opportunity. 

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About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.