Inside Volatility Trading: Going Back

Kevin Davitt
September 22, 2020

Genuine day will come

When the wind decides to run

And shakes the stairs that stab the wall

And turns the page in a future age

Some trees will bend and some will fall

But then again so will us all

Let’s turn our prayers into outrageous dares

And mark our page in a future age

Wilco – Jeff Tweedy

Sometimes it helps to go back before you try to move forward. We know a lot about the past and it can be instructive about the future. Before we run afoul with compliance—we all KNOW that past performance is not indicative of future results.

If you go back to 1928, the average daily (close over close) change in the S&P 500® Index (which wasn’t the S&P 500 until 1957) is just over 0.72%. It likely goes without saying, but 2020 hasn’t exactly been an “average” year. The question becomes, to what extent has the year been unusual and what might that mean going forward?

The average close/close change in the S&P 500 Index this year has been 1.57% (absolute value).

The average closing value for the Cboe Volatility® Index (the VIX® Index) in 2020 thru September 18 is 30.7, which implies 1.92% daily moves in the S&P 500 (0.307/16 = 0.01918).

The average closing value for the VIX Index in 2019 was 15.39. In short, the average VIX Index reading has doubled year over year.

There have been 85 sessions in 2020 where the S&P 500 closed +/-1% and 42 sessions where the daily move was +/-2%. How’s that compare to history?

Over the past 35 years, on average the S&P 500 has 65 days where it moves up or down by 1% or more during a calendar year. The average number of 2% (higher or lower) days over the same time frame is 16.

Thus far this year, 47% of the trading sessions have exhibited +/-1% “volatility” and 23% have been +/-2%. The market is on pace for ~55 sessions with 2% moves! That’s only been eclipsed in 2008, which experienced 72 such volatile sessions. 

Source: DJ S&P Indices/Cboe Global Markets

Understanding that volatility tends to cluster, if we have an unusually volatile period in and around the U.S. elections, it’s possible that 2020 could exceed the macro volatility we experienced during the “Great Financial Crisis.”

The chart above includes a five-period (annual) moving average. Trading and investing are two very different endeavors. Many people choose to trade and invest concurrently, but the time frames and goals for each are typically different. Markets have a tendency to cycle. Expansion and contraction or boom and bust depending on your perspective or the severity.

A decade ago commodities were booming. Today, the role that energies play in the S&P 500 Index is at its lowest levels ever. Real estate, crypto, Nifty Fifty, BRICs or Asian Tigers—everything cycles. Volatility is ever present, but it too exhibits periodicity.

Source: LiveVol Pro

Time will ultimately show whether equity markets have already moved into a “higher volatility regime.” 2017 was one of the least volatile years ever for the broad market. 2018 and 2019 were characterized by mostly transitory periods of elevated volatility. The average VIX Index close across that two-year period was 16.02 compared to 11.09 in 2017 (lowest ever). The markets seem to be bracing for volatility that lingers well into 2021.

Looking back to the mid-1980s, there have been three distinct periods of relatively low macro vol and at least two periods of high vol. The mid-1990s was a period of calm with consistent growth and geopolitical tranquility (Rwanda/Balkans exceptions). The late 1990s and early Aughts brought with it the tail end of the dot com boom and the volatility associated with the bust.

2004 to late 2007 (“subprime is contained”) was another epoch of relative tranquility. The S&P 500 had ZERO up or down 2% days for more than two years. Capital markets seemed impervious (we know they’re not).

As the U.S. emerged from a shallow recession after September 11, 2001—consumers did just that…they consumed! Real estate boomed fueled by a securitization frenzy. Money was cheap (as it is now) and it became a balm for macro vol.

The sheen of a cheap money elixir started to erode in late 2007 when two Bear Stearns hedge funds tied to subprime trading collapsed. By mid-March of 2008, the 85-year-old investment bank Bear Stearns was collapsing into the arms of JP Morgan for ~$2.00/share with the Fed providing a $30 billion backstop.

Capital markets remained relatively volatile into 2012. Inside Volatility readers don’t need a rehash of 2008…it was messy. So too was 2009. In May of 2010—the Flash Crash. In 2011 we had the Arab Spring, the Fukushima Nuclear disasterEuropean Sovereign Debt crisis, and the first ever U.S. debt downgrade. That was arguably the last period of persistent macro volatility in capital markets—until this year.

Eventually we’ll be able to look back at the COVID-19 pandemic and whatever occurs in its wake with some perspective. It’s too soon now. Before long the U.S. elections will be settled, which seems to be a potential period of concern for investors.

Much has been made of the “October kink” in the VIX futures curve this year. At most points it’s been prominent and with a narrative signaling uncertainty around the Presidential election. That concern now seems to be bleeding out further in time.

Another step back before we move forward.

Following the contested U.S. election of 1800 the Congress passed the 12th Amendment. Over the past two centuries there have been relatively few contested Presidential elections with the exception of 1876 (Hayes v. Tilden), 1888 (Cleveland v. Harrison), and 2000 (Bush v. Gore). “Political risk” and pandemic have been the themes of this year.

Through the lens of VIX futures and S&P 500 Index options (SPX®), the prevailing consensus has seemingly been that the 2020 election could beget meaningful market volatility. For example, on the first trading day of the year (1/2/2020) the October VIX futures settled at a 7.33 premium to the VIX Index (19.80 & 12.47). On September 16, when October VIX became the front month contract, the premium to the VIX Index was 5.10 (30.15 & 25.05).

As the September futures moved toward expiration (9/16/2020) the relationship between the October and November VIX futures began shifting. We called attention to the “Election butterfly” spread in VIX futures in the last Inside Volatility piece. Futures butterflies differ from the more typically discussed options butterfly that (often) expires at a single point in time.

Option butterfly spreads are complex strategies utilized by investors and traders to express opinions on the likelihood an underlying will expire at or near a particular price. They are constructed by combining one bull call spread with one bear call spread.

Futures butterflies on the other hand are differently nuanced. They are commonly used by traders to speculate on changes in the term structure of futures contracts.

For much of the year the relationship between October and November futures was mostly rangebound. It ebbed and flowed mostly between 1 and 2.5 wide with October always at a premium…until very recently. 

Source: Cboe

From late August until early September, October futures outperformed and the spread widened demonstrably. It moved from 0.65 (October over) to 3.875 over between August 25 and September 4. Since that Friday before Labor Day the spread has been moving the other direction, with November outperforming.

The Oct/Nov spread has shifted from Nov nearly 4 vols under to (Nov) trading at a 50-cent premium to October as of the September 17 close. This 4.375 move in the spread over a two-and-half-week time frame is fascinating.

The market’s perspective on electoral risk is apparently shifting from a “binary” situation where the U.S. president is determined on or shortly after election day, to a potentially drawn out, and volatile event. Both parties are preparing a veritable army of attorneys for a possible “extended legal battle” over the electoral process.  

The calendar marches forward. Q3 will give way to Q4. We’re in the middle of what’s historically the most volatile period for the S&P 500, in the midst of the most volatile year for the market in a decade and approaching what may be an atypical election. If we use VIX futures or SPX options as our guide, the ride into yearend could be a tumultuous one.

Interested in learning more? Cboe is also hosting a series of webinars for financial professionals and sophisticated investors in the coming weeks. The next learning opportunity on September 30, 2020 will explore Managing Global Risk Exposure – MSCI® EAFE® and EM Options. The speakers will address a recent white paper from Wilshire and harvesting premiums and cushioning multi-currency risk to improve diversification.

On October 14, Cboe welcomes speakers from the University of Providence and Alliance Bernstein to discuss Shielding Against Drawdowns – Using VIX Tradeable Products. There’s no time like the present to learn more.

“Don’t be a follower, don’t look for a leader. If he (she) could lead you into the promised land, he (she) could lead you out. Do your own thinking…And learn, instead, to think of the leaders in the same way as they think of you. That would be progress.”

Christopher Hitchens

September 22 in History:

  • 1862: President Abraham Lincoln issued the preliminary Emancipation Proclamation
  • 1949: The Soviet Union exploded its first atomic bomb
  • 1961: John F. Kennedy signs legislation establishing the Peace Corp
  • 1980: The Persian Gulf conflict between Iran and Iraq erupted into a full-scale war
  • 1994: Friends debuted on NBC





Get the Inside Volatility Trading newsletter directly in your inbox by signing up here.