Cboe Global Markets

Inside Volatility Trading: Something's Got to Give

Kevin Davitt
September 10,2020

There’s fire all around

But this is all illusion

I’ve seen better days than this one

I’ve seen better nights than this one

Tension is rebuilding

Something’s got to give

Something's got to give

Beastie Boys – Check Your Head

It’s difficult to make sense of the world today, but uncertainty (i.e. volatility) is a constant. Accepting that reality can be very empowering. The relative degrees of ambiguity waxes and wanes. Without moving into some watered down new-age philosophy or devolving into political mudslinging, in many ways it’s a matter of your perspective.

Without hyperbole, the global markets and citizens everywhere are dealing with a crisis for which there is no precedent. The human mind does a fairly good job processing events from the past, but it struggles mightily with future projections. Unconscious and conscious biases cloud our ability to discern probabilities. There is also a powerful tendency to expect a future that looks very similar to recent past.

Daniel Kahneman and Amos Tversky labeled this trait as “availability bias.” This bias tends to be unusually influential when recent memories are emotionally charged.

Is there too much recency bias at play in the markets today?

Like so many things, it’s probably a matter of your perspective.

The options markets are illustrating some ‘interesting’ (insert euphemism of your choice) realities of late. For example, the spread between short term realized S&P 500® Index volatility and forward-volatility expectations based on option values is arguably without precedent.

Patrick Hennessy, Head Trader at IPS Strategic Capital in Denver makes the point visually. The chart below shows the spread between the Cboe Volatility Index® (VIX Index®) and 21-day realized volatility (S&P 500) since 2014.

Source: IPS Strategic Capital (Patrick Hennessy)

Over a long timeframe, the typical VIX Index premium to 1-month realized vol is around 3.5 vol points (red horizontal line). There have been other periods where VIX held a substantial premium to trailing vol, but very few in recent memory. Looking back to the 2009-2010 period there may be a corollary.

After the broad market rebounded in the middle of 2009, S&P 500 historical volatility measures diminished, but S&P Index option vol remained bid. Consequently, the VIX Index maintained a meaningful premium to realized volatility.

Through the crystal-clear looking glass of hindsight, that was generally an excellent time to be strategically short index option premium. Are we in the midst of a similar epoch? Who knows? Market conviction can be beneficial or a profound detriment.

Hennessy makes the argument that “lingering fear in the market” may play a role, but he attributes the current divergence to basic economic drivers. Specifically, he highlights a potential supply/demand imbalance that’s playing out in the index option market.

Ask yourself, do you feel comfortable selling 25 delta options in the SPX® or NDX with a couple of months until expiration? If not, at what volatility level would you consider it? Or what conditions would need to be met? Of late, there has been more demand for OTM index options than there is supply.

It bears mentioning that while the market isn’t realizing large daily swings, the S&P 500 advanced by 7% in August. That was its best monthly (Aug.) performance since 1986! That represents unusual volatility too, but we more readily associate volatility with sharp downside moves. Notably, the VIX Index closed higher month over month, moving from 24.46 to 26.41 between July and August.

The prevailing VIX Index - SPX HV spread doesn’t tell the whole story. Inside Volatility always addresses VIX term structure, but it’s been receiving widespread attention in recent days. Last week a Bloomberg article headlined “U.S. Election Priced as Worst Event Risk in VIX Futures History” didn’t mince words. The graph below plots the VIX Index (green) alongside the Sept./Oct./Nov. VIX futures butterfly (blue) since they were listed in December of last year. In a more typical environment, absent an (potentially contested) election and global pandemic, a month 1/2/3 VIX futures fly would likely trade around even money. Clearly this is NOT a typical environment. 

Source: Cboe Global Markets

The VIX Index is a constant 30-day forward volatility measure. The VIX futures term structure paints a much fuller landscape. The blue line below lays out the current (as of Sept. 4) VIX term structure. The green line is early September from the last U.S. Presidential cycle and the purple line is the VIX term structure from the Feb. (2020) all-time highs. 

Source: LiveVol Pro

A few things are obvious from the visual. The front of the VIX curve at present is exceptionally steep. The spread between month-1 (Sept.) and month-2 (Oct.) futures is out to 6.50 wide. That spread has ranged from -0.575 (4/1/2020) to its widest levels yet (+6.5) as of September 4. The open interest in the October futures is now over 100k.

The other patently obvious point is that the entire curve is markedly higher than at either of the other two points in history. In mid-February, the curve was very flat, excepting October. In early September of 2016 there was a “normal” contango market and the front of the curve (month 1) was trading at 13.50 with the VIX Index measuring just over 12.

In other recent aberrant behavior, there have been three sessions with the S&P 500 higher by roughly 1% and the VIX Index also higher on the session (Aug. 26, 31, and Sept. 2). On Friday, September 4, the S&P 500 closed lower by 0.8% and the VIX Index declined by 8.5%. Most VIX watchers and volatility traders are aware of the predominantly negative (inverse) correlation between the S&P 500 and the VIX Index. Over the last five years, the correlation between the two is roughly -0.80. The positive relationship between VIX and the broad market could have indicated something afoot with the last leg higher (SPX) into this month.

One might draw comparisons to the market from January of 2018 where equities ripped higher for much of the month. Toward the end of the run (January 25-26) there was a positive relationship between the S&P 500 Index and the VIX Index before a sharp 10% correction into early February.

The more ominous resemblance is to the market of early 2000. Technology was driving the market higher. There was significant concentration in a handful of leadership names. All the while forward-volatility measures remained stubbornly high despite the equity market continuing to grind out new highs. As students of history and seasoned traders know, risk was significantly repriced in the weeks and months following. 

Source: The Daily Shot

Looking outside of the equity markets, much has been made of the weakness in the U.S. Dollar and relative strength in global currencies like the Euro. The dollar’s weakness tends to be a tailwind for commodities. Gold and silver have been strong performers of late, so too have a number of cryptos. Based on recent CFTC data a number of speculative traders (non-commercials) appear to be adding to bullish Euro positions. We’ll see if this becomes another example of a “crowded room with narrow doors” if/when the trend reverses. 

Source: S&P Dow Jones Indices

Finally, the performance spread between Information Technology and the Energy sector constituents in the S&P 500 this year has been remarkable. In general, broad-based participation (across sectors) is associated with a healthy bull market. Since the March lows, the “rising tide” was not lifting all boats. The outperformance on the part of technology harkens back to the days of the late 1990s and early 2000s.

To recap: big tech has led U.S. equity markets to new highs. The market has given back some of the recent gains between September 3 and 4 but is now ~4.3% off closing highs. Implied volatility for index options remain static/slightly higher in spite of the equity bull. The VIX futures spread may portend meaningful macro volatility associated with the upcoming election.

There are always tea leaves, but it’s a matter of how you read them.

Of course everyone goes crazy

Over such and such and such

We made ourselves a pillar

We just used it as a crutch

We were certainly uncertain

At least, I'm pretty sure I am

Modest Mouse – We Missed the Boat

The human brain is sometimes described as an anticipation machine and “making future” is the most important thing it does. (Stumbling on Happiness – Daniel Gilbert).

Good luck maintaining perspective!

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