'Rollercoaster day' in Hong Kong stresses dealers' exotic books

Autocallable knock-in levels under pressure but losses averted

Staying afloat: losses from a volatility short squeeze should be avoided

Buffeted Hong Kong indexes used as underliers for structured products have stressed dealers' exotic books but, without a further 10% fall, losses from a volatility short squeeze will be avoided.

Hong Kong indexes suffered heavy falls on July 6, but the drops were twice as steep two days later. On July 8, the Hang Seng China Enterprise Index (HSCEI) fell more than 7%, and the Hang Seng Index fell nearly 10% to register its lowest ever points fall of more than 2,000 points. While the markets have subsequently recovered some of their losses, exotic dealers have been selling volatility to hedge their books.

Retail investors in Korean equity-linked autocallable markets sell puts and collect premium on indexes such as the Kospi 200, S&P and HSCEI, which causes stress to dealers hedging this issuance when spot markets move lower and vega – dealers' sensitivity to volatility – increases. According to research by Societe Generale, 35% of vega issuance is on HSCEI, which equates to about €80 million ($88 million) in the past six months.

"Millions of dollars of vega in individual clips was sold into the market, which is surprising given the H share indexes dropped so much," says David Best, head of index flow and exotics at UBS in Hong Kong. "From December 2015 to mid-2017, huge sizes were traded in puts and straddles, which were clearly risk transfer trades between exotic books and flow desks. In other mini-crashes we have seen liquidity dry up before it gets busy, but yesterday exotic desks had to sell vol in the market to hedge their books."

It's surprising that both indexes are down 7% – that's irrational

Usually in a big spot move lower, it could take dealers several days to fully hedge their book, but they have been helped by good liquidity in the volatility market from institutional investors.

"Fast money macro funds were quoting large sizes of upside structures in HSCEI, which added liquidity to the vol market," says a dealer at a European bank.

Best says it was a "rollercoaster ride" all day, as volatility moved up in the front month by more than 10 volatility points during the afternoon. "Back-end volatility at December '15 was up one volatility point but at December '16 and '17, which are sweet spots for selling volatility as the market falls, they were almost unchanged because of the structured products flow suppressing volatility," he says.

Following a slew of measures in recent weeks to prop up the ailing Chinese equity markets, on July 8, Chinese authorities suspended hundreds of shares to avert further freefall, with mainly blue chip names still trading.

With investors unable to sell shares onshore, they started shorting offshore markets, with the Singapore Exchange's China A50 futures a prime candidate. It fell more than 11%, causing circuit breakers to be activated. The next candidates in the shorting frenzy were HSCEI and HSI.

"It's surprising that both indexes are down 7% – that's irrational," says a Hong Kong-based dealer. Blue chip Hong Kong asset shouldn't be down by that much. National support has turned into a murder on HSCEI futures."

With HSCEI trading at 11,000 points following the fall, dealers said this was within 5-10% of the peak in vanna – a measure of the change in vega for a change in underlying spot – for exotic desks. A bulk of autocallable issuance at the 14,000 mark with a 55% to 35% knock-in level leaves the 10,000 level particularly precarious for dealers hedging vega and vanna. Societe Generale estimates the extra vega hedging demand would be €10 million.

"That's still far away but people would panic as the 2008–09 short squeeze in volatility would happen again," says the Hong Kong-based dealer.

The change in sentiment in the H share markets can also be gauged by the reversal in negative skew that has been present for several months. Skew measures the difference in implied volatility between out-of-the-money, at-the-money and in-the-money options. It provides a good indication about whether investors prefer to write calls or puts.

In April, huge quantities of call option purchases left skew extremely negative but on July 8 it turned positive.

"For most of the year, H shares had negative skew at the front months, especially when the market moved to new highs and demand increased to buy calls, but skew has now turned positive as puts have been bid and demand for calls is lower," says Best.