Inside Volatility Trading: Markets - Dense and Beautiful

Kevin Davitt
May 6, 2020

It might be over soon, two, two

It might be over soon

Where you gonna look for confirmation?

So as I’m standing in the station

It might be over soon…..

Justin Vernon (22, A Million)

Justin Vernon and his band Bon Iver put out their third studio album (winter) in late 2016. Their work is circuitous, dense, ever changing, and beautiful. Last year they finished the seasonal loop when they released (spring) “i, I.”

Markets, at least from some perspectives, could be described as dense, ever changing, and beautiful. Of late, global markets seem to be pricing in a potential change in seasons…so to speak.

Shorter term (10- and 20-day) realized volatility levels for the S&P 500® have consistently declined over the last five weeks. Not surprisingly, 30-day forward (implied) volatility levels for SPX® options have followed suit.

Source: LiveVol Pro

In the middle of March 2020, historical and implied volatility measures reached their highest levels since the fall of 2008 as the S&P 500 lost 35% from the late February all-time highs. This is old news and as Bob Dylan said, “you don’t need a weatherman to tell you which way the wind blows.” The question becomes, what now? In reality, that’s ALWAYS the question.

During the month of April, the S&P 500 advanced by 13%. That was the largest month over month jump since January of 1987. The broad market is now (as of 5/1) 30% off the lows and 16.5% below its high level (reference 2830).

If we’re employing the fairly apropos analogy of a teeter-totter between global risk and greed, the market seems to searching for a new balance (pivot) point. Looking back 20 days, the SPX has vacillated between ~2750 and ~2950. For longer term, technical types, the SPX has not managed to exceed its 200 day simple moving average (SMA), which comes in at 3005, but has held above the 50-day SMA (2758) since April 24.

Source: LiveVol Pro

On one side you have a number of states lifting or loosening their shelter in place restrictions. New cases of coronavirus and daily death totals have been leveling off or declining in most areas. Global economic data has been mostly miserable but there have been some “green shoots” of potential growth.

One incontrovertible fact and potential catalyst for equity market resiliency revolves around global central banks and the Federal Reserve Bank in particular. These “lenders of last resort” have been accommodative for most of the past decade, but in the wake of coronavirus fears and dire economic data, they’ve unleashed unprecedented liquidity. You can follow the Fed's balance sheet to track their asset purchases. Keep in mind that Powell is not alone in his commitment to bolstering the financial plumbing. The European Central Bank, the Peoples Bank of China, the Bank of Japan, and many others have been following suit.

Source: Yardeni Research

In places like Germany (largest economy in Europe), Taiwan, South Korea, Australia, New Zealand, and a number of Scandinavian countries where they arguably acted early and decisively to stem the spread of COVID-19,there appears to be a pensive shift toward a new economic normal.

In the US, small cap names and the FTSE Russell 2000 Index in particular have been outperforming the S&P 500 of late. Yet again, April 24 appears to be the inflection point where the Russell 2000 began outpacing the large cap index.

On a related note, the spread between the VIX® Index and the RVX℠ Index moved from an unusual inversion (RVX discount to VIX) to historic wides over the course of the past few weeks. The RVX Index applies the VIX methodology using Russell 2000 Index (RUT) options as inputs.

Typically RVX (small cap forward vol) maintains a slight premium to VIX. As macro vol peaked in mid-March, the RVX closed at a slight discount to VIX. That’s unusual, but not unprecedented. More recently (4/17/2020), RVX closed at a historic premium to the VIX Index (+14.61). Since that point, the relative forward volatility premium in small caps has diminished relative to SPX®, but remains fairly wide (+9.04 on 5/1/2020). Keep in mind, RVX and VIX are both Indexes and are not tradable.

Source: Cboe Exchange

To take a deeper dive into the VIX index, explore the latest paper published by the CFA Institute, and co-authored by Cboe’s Matt Moran. The analysis also covers the associated futures and options, global volatility measures, economic underpinnings, portfolio management tools, and much more. It warrants attention whether you’re a professional volatility trader or you manage your own retirement portfolio and would like a more thorough understanding of the benchmark for equity volatility and the related, tradable products.

Source: Cboe Futures Exchange®

The chart above shows the VIX Index plotted against the September/October/November VIX futures butterfly. For those unfamiliar with a futures butterfly, they can move very differently than an options butterfly executed with a single expiry. In this example, the red line illustrates a hypothetical position that was long one September and November VIX future versus short two of the October VIX futures.

The October VIX futures contract incorporates the broad market’s expectation for potential US Election volatility because it’s a 30-day FORWARD look at volatility that expires in the middle of October. The election date is November 3, 2020.

The blue line plots the VIX Index. Both series begin on December 9, 2019, which is when longer-dated VIX futures were listed on Cboe Futures Exchange (CFE®). One way to potentially synthesize the data: as the broad market (S&P 500) moved higher in early 2020, the degree of idiosyncratic risk associated with the general election expanded. In short, the October VIX futures held value relative to the expiries just before and after. Ergo, the butterfly widened.

The VIX fly settled at -5.35 on February 26 (Sept = 19.225; Oct = 22.2; Nov = 19.825; VIX Index = 27.56). In late February, concern over the potential impact of COVID-19 spread and by early March risk was being repriced across asset classes.

At the same time, and until early April, the perceived risk associated with the Election became an afterthought. The same futures fly moved in to -0.625. On a closing basis the spread narrowed by 4.725 or $4,725.00/hypothetical futures fly.

As equity markets found some footing and volatility abated, the VIX futures are once again pricing in more potential US Election risk. This may be a relationship worth watching as we move into summer with party conventions and an emphasis on the general election.

With all of the talk of uncertainty, today’s blog would certainly be incomplete without wishing my amazing Mom a very happy birthday (5/4). It’s obvious that you can’t choose your family, but in my case, it would be impossible to do better. My mom is an incredible woman and it’s no stretch to say I owe her everything. I’m profoundly grateful and I love you.

She would check my writing for spelling, grammar, and content when I was in grade school and she continues to do it to this day. Thanks for reading!




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