Cboe Global Markets

Inside Volatility Trading: A Day, A Week, A Year, A Decade

Kevin Davitt
August 24, 2021

“If you think in terms of a year, plant a seed; if in terms of ten years, plant trees; if in terms of 100 years, teach people”

Confucius

A Day, A Week, A Year, A Decade

Most traders do not think in terms of a year, let alone a decade. By contrast, many investors do focus on longer time horizons, so the current market backdrop is likely appealing to investors. The S&P 500® Index is approaching 200 days since the last drawdown of 5% or more on a closing basis. Take a look back to the period just before the 2020 U.S. Presidential election for a sustained selloff in the broad market. 

S&P 500 Index Bull and Bear Markets & Corrections: 2008-2020 (Daily Ratio Scale)

Source: Yardeni Research

This type of bucolic bull run for the S&P 500 Index is not unprecedented. It is, however, the longest span since the continuous march higher from early 2016 to January of 2018. During that period, the S&P 500 Index went more than 400 days without a closing peak-to-trough pullback of at least 5% and added 57%. A quarter of the total gains for that period occurred in the last six weeks before the late January peak.

Since the October 2020 closing lows (3246) the large cap U.S. equity index has gained 37%. While the S&P 500 Index has doubled relative to the “pandemic-lows,” there has not been “panic buying” that we typically see accompanying “blow off tops” of the past.

A “blow off top” is a term rooted in technical trading. It’s the polar opposite of behavior from March of 2020, where we saw the S&P 500 futures limit down on several occasions. Typically, there’s a steep jump in prices for an underlying market on high volume. The advance in 2021 doesn’t feel like a “blow off” environment, despite record inflows into equity ETFs. By contrast, in January 2018 the S&P 500 gained ~7.5% over a three-week time frame before the eventual top on January 26. 

Volatility – Or Lack Thereof

Short-term S&P 500 realized volatility measures (10-day) have declined from ~15.5% to 5.85% as of August 13. The lowest reading since the coronavirus pandemic gripped the globe was 4.9% in early July 2021.

Cboe Volatility Index® (VIX® Index) data going back to 2011 shows July was the lowest average VIX Index measurement at 15.612. Recently, the VIX Index moved from 15.5 to over 22 while the S&P 500 Index fell 3% from highs. 

Average Monthly VIX Index: 2011 - Present

Source: Cboe Global Markets/Options Institute

The disaggregated data for monthly average VIX Index levels is below.

VIX Index Average by Month

Source: Cboe Global Markets/Options Institute

Historically, July is the least volatile month for the S&P 500, followed by June. August is in the middle of the pack, and October has been the most volatile. However, the October measure is skewed by the turmoil of 1987 (Black Monday) and 2008 (fallout from Lehman Brothers Holdings, Inc. bankruptcy). In short, we are moving into a two-month period that tends to be more volatile than the surrounding months.

S&P Global Research highlighted the fact that since 1990, the VIX Index experiences a historically higher rate of volatility in August. On average, the VIX Index has increased by 9.4% during this month. The next largest gap month is 6.0%. There have also been twelve sessions in August over the same 31-year time frame where the VIX Index jumped by more than 25%. 

Source: S&P Global Research

One factor that likely plays a role in this history is the tendency for the VIX Index to bottom in July. It stands to reason that the month with the lowest realized volatility runs in tandem with the lowest - on average - forward volatility measures. Extrapolating from there, it’s “easier” for an index to gain 25% from a low base. 

Big Changes from Low Bases (I.E., Know Your Denominator)

Imagine you purchase 100 shares of a $15 stock and 100 shares of $40 stock. Now let’s say both stocks move up by 25%. The $15 stock is now $18.75. The $40 stock is trading $50. Are you equally excited about the performance of those investments? In percentage terms – sure. In dollar terms – nope. The denominator matters.

You’re up $375 on the $15 equity. You’re up $1000 on the $40 stock.

Let’s shift our attention to percentage moves in the VIX Index. A 25% jump from 15.61 would leave the VIX Index at 19.52, a move of less than 4 vols.

Compare that to the highest average month since 2011, which is March 2020 at 20.037. A 25% advance from that level would put the VIX Index at 25.05. A more than 5 vol advance.

Now consider a more volatile backdrop, like in late January of this year after the first short squeeze in “meme stocks.” The VIX Index was near 37% at that point. A 25% increase from that level would work out to 9.25 vols higher (46.25).

In brief, the lower the base, the easier it is to experience a significant percentage move. 

A Decade of Change?

Starting points (bases) matter as does your time frame. The world and markets have experienced monumental changes over the past decade. In 2011 your access to Netflix was through the mailbox. Game of Thrones was in its first season and Contagion was a Steven Soderbergh film, not a constant concern. Jeff Bezos had a net worth around $15 billion (currently $188 billion).

Also, just over a decade ago the European Sovereign debt crisis (remember the PIIGS?) reached its “zenith.” Around that time, Standard & Poors lowered its credit rating for long-term U.S. debt for the first time ever. Between July 8, 2011 and August 8, 2011, the VIX Index moved from below 16 to 48 on a closing basis. The global bellwether for equity market risk tripled in a month.

There are a couple of potential parallels in the current market. In both cases, the U.S. had a ballooning debt to GDP ratio. S&P’s historic 2011 decision was related to government spending following the financial crisis. The current annual deficit is driven by government spending in the wake of the pandemic.

Inflation is the other primary corollary between 2011 and 2021. Between August 2010 and March 2011, the Goldman Sachs Commodity Index (GSCI) jumped more than 40%. Crude oil prices (WTI) moved from $90 to $140 in eight months.

In the nine months between November 2020 and the beginning of August 2021, the GSCI is higher by 58%. WTI Crude oil doubled between the October 2020 lows and late July 2021 highs and food prices are escalating.

A decade ago, the Arab Spring was catalyzed by rapidly increasing grain prices in the developing world (Tunisia). The tumult in the middle east drove petroleum prices higher and inflation followed suit.

Will the bottlenecks and supply/demand imbalances related to the COVID-19 recession be resolved in a more sanguine manner? Time will tell.

Economic data, including inflation readings, have been volatile recently as the geopolitical landscape shifts. Countries are struggling to contain and manage COVID variants along with other potential flashpoints including Ethiopia and Afghanistan.

While most of the equity market drivers have been positive, other factors can spill over. Change is a constant and the magnitude of its impact is uncertain. It calls to mind Nassim Taleb’s word parsing: “Don’t confuse lack of volatility with stability, ever.” 

Derivatives: Risk Management Tools

Given these parallels, perhaps the huge growth in options trading over the past two years is no surprise. Options embed volatility exposure (long/short) in a capital efficient way.

Throughout history, derivatives have been used as tools for hedging and risk management. From Ancient Mesopotamia and Greece to modern day Chicago, New York, London, Zurich, Hong Kong and beyond, futures and options can be used to offset preexisting risks.

For many years, institutions and individuals have constructed low/no premium trades using VIX options, which can provide insulation in the event of a volatility swell. The permutations are limitless given the number of strikes and expiries, but the intent of those trades often converges on managing volatility risk.

Imagine you have a portfolio that generally behaves like the S&P 500 Index (beta near 1.0). In that scenario, the 100%+ rally off the March 2020 lows is a tremendous boon. Your time frame is longer-term, but you understand the potential value of passive hedges.

Outright (long) put options on the SPX or XSP (Mini S&P 500 Index options) could be employed. So too could put spreads or collars. In most circumstances that would require some premium outlay, and if a pullback doesn’t occur, the hedge will become a slight drag on performance.

Before addressing an alternative, this take from Wayne Himelsein on Twitter shifts the perspective on the cost (and value) of protection in a clever way:

Source: @WayneHimelsein

Structured VIX Futures Hedges

Let’s say you’re opposed to hedges that have carry costs (long premium/theta exposure, etc.). You also understand that timing a market top or bottom is highly unlikely. Further, you recognize the inverse relationship between the VIX Index (and futures) and the S&P 500 Index. 

Over time, when the S&P 500 Index moves higher, the VIX Index and related futures tend to move lower. When the S&P 500 Index declines, the VIX Index and futures tend to increase.

Let’s level-set on the scenario:

  • Passive long the market with a portfolio valued at $100k and a beta ~1.0.
  • Averse to market timing strategies as well as passive hedges with potential carry costs.

This in mind, lets hedge against volatility risk with a volatility spread strategy. Imagine we place a ratio call spread with a short put in VIX options.

How does that work? Let’s use hypothetical numbers to see.

Spot VIX Index 15.50

Standard September VIX Futures: 19.40 (34 days until maturity)

  • +10 Sept VIX 25 Calls @ 1.50
  •  -20 Sept VIX 40 Calls @ 0.60 (total 1.20)
  • -10 Sept VIX 16 Puts @ 0.40

Structured options strategy executed for a $0.10 credit (or $10).

  • Downside Risk: At expiration, this approach will lose money if the September VIX futures settlement is below 15.90.
  • Upside Risk: At expiration, this approach has undefined risk in the event the September VIX futures settle above 55.10.

What are other choices we could employ?

One way to define the upside risk would be to turn the ratio spread, which is net short one unit (+1call and -2calls), into a butterfly. The September VIX 25/40/55 call butterfly packaged with the short September 16 strike put in VIX could have been executed for roughly a $0.20 DEBIT.

The result? Defined risk in the event of a huge jump in September VIX futures. Positive volatility exposure/risk offset in a situation where the September VIX contract expires between 25.20 and 54.80.

Downside VIX futures risk in a situation where the September contract expired below 16.20.

Keep in mind that if VIX futures move lower, the S&P 500 is likely stable to higher which is where, in this scenario, your portfolio risk is concentrated.

What if expected volatility measures increase?

If the September VIX futures expired at 40 (best case scenario), the position (butterfly and short put) would be worth ~$14,800. 

September VIX Futures Expiry at 40

Source: Cboe LiveVol Pro

In our hypothetical scenario at expiration, utilizing the VIX option ratio spread (or butterfly) and short put structure would offset roughly a 15% decline in the portfolio value. That’s powerful potential protection for a low (butterfly) long premium hedge, or no premium in the case of the ratio spread. 

The Uncertain Path Forward

Sometimes we’re concerned about tomorrow or next week. Perhaps our primary portfolio considerations are a year or a decade in the future. In either case, the path is rife with uncertainty.

We can choose to blindly follow whatever path of returns that the market carves out over a given time frame. Plenty of people make that choice. Others understand there are powerful tools that can help illuminate and potentially insulate the future path.

Those tools include options on the VIX Index, the S&P 500, or Russell 2000. For those with more international exposure, MSCI’s index options. In the OI, we encourage continuous learning, especially when it comes to derivatives. We welcome you at an upcoming event and look forward to seeing you there soon. 

Industry News

Events

  • Coming Soon: Back to School Volatility Webinar Series led by Sheldon Natenberg & Dave Silber. Registration for the Sept 14th webinar opens soon at cboe.com/education/#events

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Past performance is not indicative of future results. Hypothetical scenarios are provided for illustrative purposes only. The actual performance of financial products can differ significantly from the performance of a hypothetical scenario due to execution timing, market disruptions, lack of liquidity, brokerage expenses, transaction costs, tax consequences and other considerations that may not be applicable to the hypothetical scenario.

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