Record low HSCEI skew as Hong Kong markets boom

Call option volumes trebled in April as bourse hits multi-year highets boom

Call option interest outpacing the demand for puts on Chinese stocks has caused the volatility skew on the Hang Sang China Enterprise Index (HSCEI) to turn steeply negative and is reminiscent of 2007, when the market peaked before a precipitous fall.

HSCEI three-month 105–115% skew is at minus two volatility points following big market moves in the underlying index. Hong Kong's benchmark Hang Seng index (HSI) shot up 7.3% on April 9 before retreating but is still at a multi-year high of 27,000 points, while the HSCEI is at a five-year high of 13,800 points.

"In 2007 the HSI and HSCEI had negative skew with volatility of upside options being higher than downside options. This phenomenon exists in extreme bull markets," says an equity derivatives source at a global bank in Hong Kong.

Volatility 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.

Indeed, some dealers view the current market configuration as a sign of an overheating market and are pitching risk-reversal trades to hedge funds to take advantage of these dislocated parameters.

While the prevalence of structured products, such as reverse convertibles and autocallables – where investors sell embedded options – tend to depress volatility in Asia markets compared to their more developed peers, this trend is now more pronounced than ever.

"The inverted skew (below the first percentile) in the HSCEI makes it attractive for investors to play the risk-reversal trade by purchasing puts and selling calls. There has never been a better time in the past five years to put on that trade. By contrast S&P skew is in the 99th percentile so it's the worst time in the past five years to buy puts and sell calls," says the equity derivatives source.

As well as the structural element of insurers purchasing S&P puts to protect their portfolio, dealers say a recent broader increase in put purchases has brought S&P skew into the 99th percentile.

The negative skew on Hong Kong indexes was exacerbated after investors piled in to the upside. "Everything centred around HSCEI and HSI during the past few days. April at-the-money volatility was up five vol points and its June equivalent was up by three. The negative skew is at a record low – upside is even steeper than it was in 2007 – driven by bullish upside call buyers," says Ann Tranqui, head of flow derivatives sales at Societe Generale in Hong Kong.

Several factors have recently boosted the Hong Kong indexes. On March 27 China allowed fund managers to invest in Hong Kong-listed equities via the landmark stock connect programme. Previously they required a qualified domestic institutional investor license despite stock connect being live since November. As a result volumes on Hong Kong have reached record levels with more than $37 billion of turnover on the Hang Seng yesterday.

While most of these buyers invest in cash rather than derivatives it is adding momentum to the overall investment story. Several China shares dual listed in Hong Kong are also trading at a discount after a year-long rally in the Shanghai A share market, which is also enticing investors.

Winner Lee, Asia equity and derivatives strategist at BNP Paribas says that from a listed option perspective there has been huge demand for HSCEI calls. But for HSI, there was an increase in both calls and puts. HSCEI option liquidity spiked to $9.7 billion notional on April 9, triple the March average of $3.2 billion.

"The flat skew is due to strong demand on call options and probably also from structured products selling puts, thus, lifting up the upside volatilities and depressing downside volatilities," says Lee. "Thus, the HSCEI upside and downside skews are in negative territory, while we witnessed strong demand on HSCEI calls in the listed market and it was likely the OTC followed this trend."