Cboe Global Markets

Inside Volatility Trading: Exploration & Exploitation

Kevin Davitt
December 15, 2020

I don't know where the sun beams end and the star

Lights begins it's all a mystery

And I don't know how a man decides what right for his

Own life, it's all a mystery

-Flaming Lips Fight Test

Exploration & Exploitation

Time has taken on an unusual characteristic in 2020. The Earth continues to spin and is about to complete another annual orbit around the sun. However, hours, days, weeks, even months have taken on an amorphous quality during the COVID-induced pandemic. The shapeshifting nature of this year has given rise to opportunities and risk.

Of late, I’ve been reading Range: Why Generalists Triumph in a Specialized World by David Epstein and rereading Jack Kerouac’s, The Dharma Bums. The former augurs the value of wide “sampling” in life as opposed to a rigid pursuit of excellence in one arena. Epstein’s thesis is supported anecdotally as well as with research, like the “multi-armed bandit” studies, which we will elaborate on shortly.

Kerouac’s Dharma Bums is a follow up to On the Road. This story follows Ray Smith as he “samples” different approaches to life from urban excess to contemplative isolation in nature. Ray is trying to discern his path to transcendence, or general happiness, through experimentation.

Research from Cornell University suggests that we make about 35,000 conscious decisions daily. That works out to roughly one million decisions a month. The Options Institute offers a course on decision-making stemming from the belief that like any other process – it can be improved. As a New Year approaches, many set out to change a habit or two. If you’re inclined to set a high bar, perhaps venture to improve your decision-making process in 2021.

Options Abound

Option traders encounter a relatively high number of choices. There are more than 5,000 optionable equity, ETF, and Index products available to market participants at present. If we consider just the SPX® Index options, there are about 31,000 potential calls or puts available. There are expiries every Monday, Wednesday, and Friday for the next six weeks. There are expiries listed until December of 2022 with the 2023 cycle forthcoming. 

How can we choose the best products to trade? How do we determine the time frame, strategy, entry and exit?

One approach would be to EXPLORE.

In Dharma Bums, Ray spends time at raucous Bay Area parties. He also retreats with a small group of friends into the Sierra Nevada mountain range to experience nature. Eventually he chooses to spend a considerable amount of time alone in the wilderness. Ray, like Jack Kerouac, is an explorer in search of truth and knowledge.

David Epstein analyzed the (often meandering) paths that successful people followed to the top of their respective fields. He dispels, to a certain extent, the pervasive belief in the 10,000 hour rule. The Range author argues that rather than focusing exclusively on an area of interest, one is better served sampling a wide variety of paths without emphasis on a specialty. The goal is better “match quality” between our abilities, interests, and the work we pursue.

Exploration in this context offers a wide variety of information signals. In theory, the more signals, the more likely we are to discern what makes us truly fulfilled. It’s worth noting though that what we find most meaningful at age twenty is likely to be very different than at thirty, forty, fifty and beyond.

Data scientists will often employ a multi-armed bandit study in situations where there are a variety of potential opportunities to help determine an optimal future decision. One armed bandit was a moniker given to old Las Vegas slot machines. To this day they are programmed for specific payout ratios. The problem-solving approach attempts to determine the ideal choice via exploration and exploitation. RitvikMath explains the concept in greater detail for those inclined.

‘Exploitation’ is a term like ‘volatility’ where the word has a different denotation in economics than what it typically connotes in everyday life. In multi-armed bandit theory, exploitation refers to making choices that we believe to be best based on past outcomes.

Explore alternatives, gather information, test validity, and continue to evaluate and refine.

Sounds like an approach that could be employed in the markets.

The Markets

This Friday (12/18) is a quarterly (Dec.) expiration. A significant amount of options open interest (roughly 5.5M OI) will roll off on the 18th. The Dec. quarterly expiry tends to beget high volume before the options market goes into a typical end-of-year lull. With the SPX Index at all-time highs going into expiration week, much of the open interest is currently out of the money.

Following the Dec. expiration, Tesla will be added to the S&P 500® Index. As the visual below from The Daily Shot illustrates, Tesla’s current market capitalization recently exceeded the combined market cap of Toyota, Volkswagen, Daimler, and General Motors.

Source: Refinitiv Datastream

Tesla shares have gained nearly 700% YTD. It’s currently valued at more than $600 billion, which is more than Berkshire Hathaway (A shares) with a valuation of about $550 billion.

Given Tesla’s size, it will become a top tier constituent when added to the S&P 500. That has the potential to introduce greater volatility to the entire index. The visual below shows the longer-term realized volatilities (90D /120D/180D) for Tesla. The blended average is right around 80%.

Source: LiveVol Pro

For comparison’s sake there’s also a look at the other top holdings in the S&P 500 Index and a blended average of their respective (longer-term) realized volatility levels. What impact do you believe the addition of TSLA to the S&P 500 will have on macro Index implied and realized volatilities?

More Macro

The annual (calendar year) average VIX® Index measure since 1995 is just over 20. If the year ended today (12/10) the annual VIX average would be just below 30 (29.72). 2020 will be the highest average VIX Index measure since 2009 (31.48). The past decade has been far less volatile than the previous 10-year span. The average annual VIX reading since 2011 is 17.6.

By every measure, this year has been unusual, but since the election, volatility measures have fallen dramatically and are back near long-term averages. If we look back one month, the average VIX Index close is 22.27.

The 1-month S&P 500 realized volatility index has fallen below 13%. That measure has only been below 13% between January 1 and February 19 (old highs) and between August 4 to September 2 (another new high).

The last session where the S&P 500 moved by more than 2% was on November 4, just after the election. Granted there is limited data, but the average close-over-close change for the SPX in December is about 40 basis points. The chart below highlights the average daily change (absolute value) in the S&P 500 (SPX) for each month of the calendar year. Thus far (through 12/9), December is the least volatile on average.

Source: Cboe Global Markets

Term Structure

Given the backdrop described above, perhaps it’s no surprise to see the shift in the VIX futures term structure over the past five weeks. The purple line illustrates the VIX futures curve on the close the night before the election. The December VIX futures closed at 31.35. The blue line represents the VIX term structure as of December 9. The Dec. VIX futures closed at 22.65, down 8.70 over that time frame.

Source: LiveVol Pro

The futures curve moved from backwardation into its more typical contango. In fairness, the long-dated futures are still trading with a 25/26 handle, which is well above “normal” for a back month VIX future.

For those that view the path forward through a “glass half empty” lens, a recent Bloomberg article calls attention to some concerning metrics. In arguably the most concerning comparison, the CAPE Shiller ratio puts current S&P 500 valuation above the 1929 peak (albeit well below the dot com zenith).

Odds & Ends

Cboe’s web design has been working in conjunction with the Options Institute to update the look and feel of our site. This is a considerable lift and the effort continues, but you can check out some of the improvements!

Industrial metals like copper and iron ore have been trading at multiyear highs.

Equity call option demand continues to boom, which has pushed put/call ratios to two-decade lows.

Source: The Daily Shot

While 2020 will undoubtedly be remembered as the year of the pandemic, Special Purpose Acquisition Companies (SPAC) have come roaring back as well. There have been at least 218 IPOs brought to market as SPACs. There had been a TOTAL of 226 SPAC offerings between 2009 and 2019.

The IPO craze continues as well with DoorDash going public. The company closed with a market cap of roughly $60 billion on its first day. That’s a higher valuation than Progressive Corp. (PGR - $55B) and slightly lower than CSX Corporation (CSX - $68B). Airbnb is one of the next highly anticipated offerings. You can track the Renaissance Capital IPO market with their ETF which is up nearly 110% YTD. The top holdings include Moderna, Uber, Zoom Video, Pinterest, and CrowdStrike.

There are two and a half weeks remaining in a year that absolutely nobody expected. Uncertainty is endemic to the human condition as well as capital markets. Here’s to plenty of exploration and exploitation in the year ahead. In keeping with the zeitgeist of the year, my family adopted a new dog (after saying goodbye to our old dog). Rory is a Plott Hound mix from Paws Chicago and this guy is an EXPLORER. 

A very safe, happy, and healthy holidays to all.

“One day I will find the right words, and they will be simple”

– Kerouac, The Dharma Bums

Headed out to where the pavement turns to sand

With a one-way ticket to the land of truth

-Neil Young Thrasher


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