Last year we described a year end trade where our fund took advantage of a homogenous positive move in the convertible bond market basis. This was seasonal in nature and we hedged our long convertible bond position with long volatility in the bond market. We unwound this successful trade in late January.

Where does this leave us now? Our convertible bond exposure is now very small and getting smaller as prices improve. We are expecting a short term improvement as U.S. rates made a large move down in the last week or so and the convertible bond market normally takes a few weeks to catch up. We will be selling into any improvement in the basis (an improving basis can be viewed simply as price improvement relative to fair value). We consider convertible bonds in general to be over-valued by about 7%. If a bond manager is levered three to one and prices correct by 7%, a loss of about 20% or so could occur.

Volatility or vega (option prices) has reached mid-range levels from very cheap levels. This occurred very quickly over the last ten days or so. We used this opportunity to sell some index volatility against the long vega that we had built up over the last several months in individual stocks. We sold approximately 25% of our vega out through index options.

We are not sure if volatility takes a little breather here or continues to go higher. The supply and demand of options is more balanced now, but the skew is still relatively flat (from very flat levels). My guess is that we are in the beginnings of a major move higher in volatility, but this could take a while and start again from lower levels.

Debt continues to grow in all sectors of the economy and this leads us to continue to be a buyer of volatility over the long term. We are always long gamma (change in delta), which is very different (I will make this clear in an article on the new VIX futures) from vega (change in option prices); both are a component of convexity.

Note:  This analysis is offered in the vein of education and is not intended as advice.