Cboe Global Markets

Inside Volatility Trading: What's Old Becomes New Again

Kevin Davitt
January 14, 2021

“I am thee and thou art me and all of one is the other”

-Ernest Hemingway, For Whom the Bell Tolls

In the middle of the 14th Century, a “Black Death” descended on the world and spread rapidly across modern-day Italy and North Africa and into Austria, Hungary and Switzerland. Eventually spreading into Spain, France, and England. Europe was ravaged multiple times by recurrences.

Improved hygiene, including cremations, as well as quarantines contributed to the eradication of the worst global pandemic ever.

Painful points in history can be instructive. We are in the midst of a very difficult fight to stem the spread of COVID-19. The implications of the ongoing pandemic continue to unfold. If history is a guide, there will likely be both positive and negative ramifications.

The social and economic impacts of the Plague were seismic. There was a catastrophic decline in trade, the relative importance of religion was called into question and wars were not waged. The human toll was beyond calculation. The amount of land that could be cultivated was constrained by lack of manpower. Over time this rattled the foundation of the feudal system whereby landlords were dependent upon serfs (laborers). Wage pressure percolated as years passed and the profound rigidity of European society gave way. More and more capital (in various forms) flowed to groups that for centuries were indigent/subsistent.

History, like investing, can often be defined by epochs with the benefit of hindsight. The Middle Ages give way to the Reformation, which cedes to the Enlightenment and eventually the Industrial Revolution.

What types of changes will the most recent pandemic bring about in the coming years? What might that mean for your investments?

NYU Professor, Scott Galloway argues that the COVID-19 pandemic will be viewed as an “accelerant” to social, economic, personal, and political trends. The dominance of technology-savvy platform companies has been evolving for more than a decade. The Stay-at-Home economy became a new catalyst. Amazon for shopping. Netflix, Spotify, Disney, Roku and others for entertainment. Remote health care and education (Zoom) alternatives.

These shifts had been occurring, but coronavirus quickened that rate of change. Galloway’s 25-minute presentation can be viewed here.

Macro Volatility Shifts

Change is a constant, but the rate of change can vary greatly. The velocity of change in 2020 was unusually high in most capital markets. To wit, on December 31, 2019 the 1-year realized volatility for the S&P 500® fell to 12.56%. By contrast, on December 31 of 2020, the same volatility measure was 34.69%!

Looking back 10 years, the previous high for 1-year S&P 500 historical vol was ~23.30%. That occurred in late 2011 and mid-2012. 2011 will be remembered as the year of the Arab Spring, the tsunami and subsequent Fukushima nuclear meltdown, Portugal, Italy, Ireland, Spain, and (most notably) Greece default concerns, as well as the first (and only) downgrade of U.S. Treasuries. The S&P 500 closed 2011 down 0.003% for the year.

The high-to-low range for calendar year 2011 was 264 S&P handles. Relative to the Index’s starting point of 1257.60, that works out to a 21% range. In 2020, the peak to trough values worked out to just over 1418 handles on a closing basis. Relative to the S&P 500 close at the end of 2019 (3230.78), it was a 44% range. The S&P 500 closed the past year higher by 16.3%.

Source: S&P Global

From an investment standpoint, it’s possible that what’s old becomes new again. For example, there’s been considerable coverage of the potential reemergence of the “short-vol trade” gaining steam again. A Financial Times article highlighted some of the shocks to volatility markets since 2007.

Time Frames Matter

An imperfect, albeit instructive, analogy for the short vol trade is selling insurance against “stock market squalls and pocketing the premiums that other investors pay*.” There’s a natural demand for protection against drawdowns in the equity market. There’s also a community of dealers and market makers that are typically willing to assume and manage the risk associated with selling protection.

Over long time horizons, selling insurance and managing derivative risk with an implicit short volatility bias tends to be profitable. It’s imperative, however, that we call attention to the time horizon as well as the necessity for deep pockets and risk controls for those that engage in this type of approach.

It’s easy to point out the tendency for implied volatility of index options to trade at a premium to the subsequent realized volatility of the underlying market. Averages can distort the reality that occurs when multiple standard deviation events occur (and they do).

Volatility shocks can cost firms significant amounts of money depending on their exposure, offsetting positions, and whether they are able to shift the risk out in time. Episodic vol events like the Chinese Yuan devaluation in late 2015, North Korea nuclear concerns, tariff uncertainty and the significant selloff that occurred in early February of 2018 can be cataclysmic for those with too much exposure.

In circumstances like those (exacerbated by leverage), the “averages” and “long time horizons” may not matter. In the moment, the move, the P&L, liquidity constraints and the system are front and center. Sometimes, individuals or firms are unable to weather the idiosyncratic operational risk. It calls to mind Hemingway’s The Sun Also Rises where Mike Campbell is asked how he went bankrupt. His response is oft quoted and apropos: “Two ways. Gradually, then suddenly.”

The System

The system,” by which we mean the global plumbing mechanism that moves risk and capital on a daily basis, works. Again, over long-time frames, the system has benefited people, institutions, and states with higher standards of living, greater productivity, and more stability. We don’t lead the “solitary, poor, nasty, brutish, and short” lives that Thomas Hobbes described in The Leviathan. That’s due in no small part to the evolution of dynamic markets. 

However, you could argue that the systematic solution to the problems that have rattled the foundation over the past 15 years or so may be impermanent.

Has cheap money become the cause of and solution to all the macro volatility trauma?

Time will tell, but in fairness, there is no shortage of market pundits who have called the actions of global central banks into question for the past decade. In general, their (often Austrian school of economics based) thinking has proven incorrect.

While there’s undoubtedly evidence of “malinvestment” (Fredrich Hayek’s term) when we look back at the period leading up to March of 2000 and the fall of 2008, it’s impossible to know if it’s different this time. Fear of missing out (FOMO) can be a very real motivator in any market. Are there examples of that in the markets now? Possibly.

Overall, capital tends to flow where it’s most productive. Technology has fomented massive improvements in productivity. At what cost? That may depend on what you do for work and whether you have investments. In short, it’s subjective.

Odds & Ends

As an industry, we celebrate the growth in derivatives trading over the past year. The record-setting volume numbers are a testament to a variety of catalysts including the Stay-at-Home economy, but it’s also a tribute to a far greater understanding of the utility of calls, puts, and futures contracts in a period of massive uncertainty.

Derivatives were designed as tools to help manage risk. Risk measures have been and remain elevated. A growing subset of the investment community recognizes that reality and has embraced these tools as a means to gain exposure or manage risk over specific time frames. It also shines a light on the tremendous opportunity for further understanding of the how and why these powerful tools work. We shoulder a portion of that responsibility and welcome opportunities to bolster investor IQ. 

Source: The Options Clearing Corporation

The U.S. Dollar Index sits slightly above five-year lows. The strengthening that transpired between early 2018 and early 2020 has been erased. The question becomes: what now and what are the possible implications. 

Source: Trading View

Unique, but related, the Treasury Yield curve continues to steepen. The spread between short- and long-term rates continues to widen. The difference between the yield on the U.S. two-year and 30-year products is back out to 100+ basis points. That’s higher than it’s been in more than three years.

The 10-year treasury yield broke back above 1.0% for the first time since the S&P bottomed in the middle of March. Inflation expectations have advanced as have many commodity prices. Cryptocurrency values have skyrocketed. Bitcoin values have doubled in the past six weeks and the value of all bitcoin in circulation is now ~$775 billion after having briefly exceeded $1T last week. 

For some context, Tesla’s market cap has also grown to roughly $880 billion. That’s interesting. Elon Musk also happens to be a vocal proponent of decentralized, digital currencies.

Over the past three months, Emerging Markets have come charging back. The MSCI Emerging Markets Index (MXEF℠) has advanced by ~21% whereas the S&P 500 is higher by ~10.5%. The MXEF Index tracks the performance of mostly large cap companies from emerging market economies. Chinese firms dominate, making up nearly 40% of the constituency. That’s followed by South Korea and Taiwan with 13.5% and 12.7%, respectively. Firms from India, Brazil, South Africa, Russia, Saudi Arabia, Thailand, and Mexico round out the most significant geographic components. 

Source: Cboe Global Markets

Cboe lists Index options on the MXEF Index which is very similar to the iShares MSCI Emerging Markets ETF (EEM). The Index options, however, have a significantly larger notional value. They are also cash settled, European styled, and are likely considered 1256 contracts in the eyes of the Internal Revenue Service.

That combination of features lend itself to potential commission and tax savings. With all things tax related, please consult a professional before making investment decisions.

Options volume on MXEF have also grown in recent months. We have observed a number of Institutional type structures (based on executed size) hitting the tape. Generally speaking, the approach has been long, slightly out-of-the-money call spreads with approximately three months until maturity that are financed by the sale of OTM puts with the same expiry.

Finally…

On January 9, 2020 the Chinese media reported that their researchers had identified a novel pathogen in the Wuhan province. The implications of COVID-19 cannot be understated. To some extent, EVERYTHING has changed.

One year later, the global barometer for equity market risk (VIX® Index) is 10 vols higher than it was in early 2020 (22.5 vs. 12.5). Equity markets, options, and the VIX Index are forward-looking tools. Despite the mounting death toll and recent global resurgence, the current outlook seems to forecast economic improvement, but with wider potential deviations.

Those fortunate enough to survive the Bubonic Plague navigated change that would give rise to very real improvement. As we mentioned, time frames matter. Nobody in 14th Century Europe was around to experience the Enlightenment, but time marches on. Uncertainty will not subside, but 21st Century populations have a far better understanding of our situation, as well as tools like derivatives to potentially allay our exposure…at least in the capital markets!

“I did not care what it was all about. All I wanted to know was how to live in it. Maybe if you found out how to live in it you learned from that what it is all about.”

Ernest Hemingway – The Sun Also Rises

*The Financial Times – Jan. 3, 2021

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