Four Strategies for Managing GCC Volatility

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Four Strategies for Managing GCC Volatility 13 - Feb - 2007

Markaz has recently published a report suggesting four trading strategies to take advantage of the high volatility of GCC markets. These are: 1. Relative volatility strategy 2. Contrarian strategy 3. Technical strategy & 4. Options based strategy. 1. Relative volatility strategy: M.R. Raghu, Head of Research at Markaz observes that similar to stock prices, even volatility goes through wave-like patterns alternating between high volatility and low volatility. It is observed that periods of high volatility will be succeeded by falling share prices and vice-versa. Accordingly two stocks can be combined as a portfolio whose allocation between them will depend on the relative volatility. The strategy would be to reduce weight to the stock whose volatility is increasing and increase weight to the stock whose volatility is decreasing. The selection of the stocks will depend on their price relationship (correlation). It is better to look for stocks that are less related to each other (low correlation). Much against the popular belief that GCC markets are strongly related, Raghu notes that during year 2006 the relationship dropped across the board. The highest correlated market in the GCC was Dubai and AbuDhabi at 0.53. Saudi Arabia moved in the opposite direction to many developed and emerging markets providing, thereby making it an attractive option. This strategy seems to outperform a direct exposure approach. For e.g., a combination of Saudi Arabia and USA based on this strategy will give the following results: While the strategy performance is lower than S&P 500, it is considerably higher than a stand alone Saudi exposure. The report presents other such combinations. 2. Contrarian Strategy: Another strategy would be the contrarian strategy where a trader buys when the market dips and sells when the market rises. Initially, the trader establishes a fixed “equity: cash” ratio and rebalances the portfolio at periodical intervals to revert to this constant mix. For e.g. if the equity:cash ratio of 60:40 and the trader decides to rebalance at the end of every day, he will have buy on days when market falls and sell on days when market rises. The success of this strategy will depend to a great extent on the extent of volatility. The higher the volatility, the better will be the success. Application of this strategy to some of the most volatile stocks in the region provided good results, as follows: 3. Technical Strategy: Traders can also employ technical strategies that depend on volatility. While there are many technical strategies, Raghu recommends Bollinger Bands. Thanks to John Bollinger, this technique using moving averages with two bands (upper and lower) allows users to compare volatility and relative price levels over a period of time. Research by Markaz shows that Bollinger Bands provide very good trading signals for all GCC markets. The following presents a study on Kuwait market. 4. Options based strategy: Given the abundance of volatility in the GCC stock markets, derivatives strategies can be profitability employed to take advantage of this. The basic idea would be to write options on stocks. Options written on stocks with high volatility tends to command higher premium than otherwise. The “free-float” for many large and mid cap stocks is relatively low compared to other emerging markets. This is due to high strategic holdings by government and families. The strategic holding (non-free float) tends to be dormant and not traded in the stock markets. Ability to write options on this will enable the owners of the shares to make money through option premiums. However, in GCC only Kuwait has some form of options, where Markaz writes call options on 45 stocks. Apart from explaining the four strategies, the report also measures volatility in the GCC market. Measured on the most used scale of standard deviation (daily standard deviation annualized), Raghu observes that during year 2006, international stock markets witnessed increased levels of risk with emerging markets reporting marked increase compared to developed markets. Among emerging markets, India witnessed a sharp increase in the standard deviation from 17% in year 2005 to 26% in year 2006. Among developed markets, Japan experienced the maximum increased in standard deviation from 13% to 20%. S&P 500 exhibited lowest risk at around 10%. GCC countries experienced relatively very high risk compared to other international indices. Among GCC, Saudi Arabia, Dubai, Abu Dhabi and Qatar exhibited high levels of risk while Kuwait, Oman and Bahrain has been at levels comparable to other international markets. The increase in risk for Saudi Arabia has been remarkable from 24% to 49% literally doubling. The report also examines stock price returns greater than or less than a certain limit. It typically answers a question like this: among the total number of trading days, on how many days did the stock market showed change of more than 2%? The higher the number, the higher the risk and vice versa. Raghu reports that Saudi Arabia reported changes of more than +/-2% on 97 days out of 247 trading days during year 2006. This is roughly 40% of trading days. Dubai was not far behind with 86 days, followed by Qatar at 62 days. Compare this with say S&P 500 that reported only 2 days out of 251 trading days (0.8% of the days). Among emerging markets, the highest was from India where out of 250 trading days, 44 days reported changes of in excess of +/- 2%. Kuwait, Oman and Bahrain again exhibited trends comparable to other developed markets. The top 4 volatile stocks of GCC came from Saudi Arabia during the year 2006. Saudi Electricity topped the volatility chart for year 2006 among GCC heavy weights with a standard deviation of 77% followed by Al-Rajhi Bank at 66% and Sabic at 57%. National Bank of Abu Dhabi (54%) and Emaar (53%) also exhibited above-normal volatility. Agility (earlier known as PWC) reflected highest volatility (40%) among Kuwaiti companies. Commercial Bank of Qatar (40%) topped the chart followed by Rayan Bank (38%) for Qatar . However, Rayan Bank traded only for the part of the year being a newly listed stock. In Oman, Raysut cement (28%) topped the list. National Bank of Oman (17%) enjoyed the lowest volatility among all GCC heavyweights. Among the top heavyweights in Bahrain, companies like Investcorp and Batelco suffered very low levels of liquidity. For e.g., Investcorp traded only 15 days while Batelco traded on 19 days. Gulf Finance House (41%) topped the vol chart for Qatar, Oman and Bahrain respectively. On 30% of the days, GCC heavyweights reported single day change of more than +/-2%. Five companies reported changes of more than +/-2% on over 100 days during the year 2006. These were: Emaar (138), Agility (132), National Bank of Abu Dhabi (126), Industries Qatar (125), & Commercial Bank of Qatar (107). In summary, GCC markets display considerable volatility in price movements. Left to itself, this volatility simply means taking more risk and may not offer commensurate rewards. However, if we can employ strategies that require presence of volatility, it might be a profitable idea. Kuwait Financial Centre 'Markaz', with total assets under management of over KD1.25 billion as of September 30, 2006, was established in 1974 has become one of the leading asset management and investment banking institutions in the Arabian Gulf Region. Markaz was listed on the Kuwait Stock Exchange (KSE) in 1997; and was recently awarded a BBB+ corporate rating by Capital Intelligence Ltd.