Merrill Lynch is recommending buying straddles on Hong Kong's Hang Seng Index, based on probability methodology rather than commonly-used vol pricing. "We used sample statistical analysis to determine the trending of markets as opposed to just modeling volatility," said Arik Reiss, director and co-head of Pacific Rim equity derivatives strategy in Hong Kong. He argued large 'hot money' flows can easily shape the directional trending of markets in Asia, but right now volatility is suppressed in Hong Kong due to the large amount of structured product issuance. The HSI is an attractive index for a probability-based straddle-buying strategy because it does not appear to fully price in the risk of speculative flows triggering a volatility pickup, he added.
The firm suggests buying a one-year straddle, with implied volatility currently around 14%, then sell either the put or the call as soon as a major move in volatility can cover the premium paid for the straddle plus a desired hurdle rate of return. The premium cost is 11%.
