Inside Volatility Trading: So, Now What?

Kevin Davitt
November 17, 2020

I had this crazy idea

Somehow we coast to the end

The change lies in every direction

So now I guess we’ll just begin again


So…. Now what?

Heraclitus is a lesser-known Ancient Greek philosopher. He predated Socrates and led a distinguished life. He was one of the first process philosophers and focused on the concept of change, or becoming.

Heraclitus observed that nature is in a constant state of flux. He’s believed to have said “the only constant in life is change.” A statement like that may now seem self-evident, but there’s also a very natural inclination to resist those inevitable variations. We observe the tendency in everyday life as well as in markets.

Capital markets evolved into efficient means for expressing sentiment about potential change. Options markets offer an alternative exposure to future volatility; in other words, the rate of change. We know change is constant and 2020 has reiterated that point thoroughly. The political, public health, cultural, and capital arenas look very different globally. Very little, if anything, remains the same.

Looking at the past two months in the volatility market, the relationship between (current) front month VIX® futures (November) and the December futures has vacillated meaningfully. Over the past two weeks, the spread moved from November trading 1.275 over December (backwardation) into the more typical contango as the November contract moves toward expiry (11/18/2020).

Source: Cboe Global Markets

Historically, a backwardated VIX term structure has been indicative of a market in flux. Following the election, volatility markets have reverted to their more typical carry/contango market, but the entire VIX curve (and SPX term structure) remains elevated.

The rate of change in 2020 has been atypical. In a September Missive we highlighted that on average (35-year history) the S&P 500® has 65 days (annually) where the close over close move is +/-1%. Thus far in 2020 there have been 103 daily moves of more than 1%. On 42 (of the 103) days, the broad market moved higher or lower by at least 2%. It’s no wonder the average VIX Index closing level YTD is 30.34.

Source: Cboe Global Markets

VIX and Mini VIX™ (VXM) futures volume has been strong for the past month. There was a notable jump in activity in both contract sizes in late October as the S&P 500 fell. Standard VIX futures trading picked back up around the election as the curve fell and flattened. Volume for both products increased again on the hopeful vaccine news. As mentioned in the previous newsletter, the number of unique accounts participating in the VXM market continues to grow. For more details, you can visit the Cboe Futures Exchange Daily Market Statistics page. 

Source: Cboe Global Markets

Lingering concerns remain about election lawsuits in swing states ahead of the December certification by the Electoral College. COVID-19 spread is bad and getting worse with the potential for new restrictive measures on a state by state basis. There’s also been no material headway on a second stimulus package in the U.S. Congress.

Nevertheless, in the month of November the S&P 500 Index has rallied ~7.8%. The small-cap Russell 2000® Index (RUT℠) jumped 10.5% and made new all-time closing highs (11/10). Over the same time frame, the NDX advanced 6.8%. There’s been a conspicuous rotation taking place in the equity markets of late. In general, there’s been underperformance on the part of the old leadership (big tech/story stocks) and a move into value/laggards.

On Monday, November 9, positive news about the trial PFE vaccine efficacy sent investors scrambling. The chart below illustrates the historic fluctuations between the Russell Value Index (RLV) over the Russell Growth Index (RLG) in the days after the election. Growth outperformed by more than 4% on 11/4 (and for most of the year), which unwound viciously on November 9 with the single largest RLV outperformance ever.

Source: Credit Suisse

According to TradeAlert, November 9 was the busiest day in the history of options (48.2M), surpassing the massive volume from February 28. It was also the most active call trading day in single stocks ever.

In Asia, the exodus from big tech names has been far more pronounced during recent sessions. Chinese bellwethers like Alibaba, Tencent, and have fallen around 10% as a result of efforts on the part of the (Chinese) government to reign in their “monopolistic behavior.” The Hang Seng Tech Index lost 11.1% in two sessions early last week. Facebook, Amazon, Apple, Microsoft, and Google lost a total market value of roughly $350 billion over the same time frame.

While significant concerns endure, longer dated Index options volatility continues to deflate. Midyear 2021 (June) SPX® ATM implied volatility is down to 20%. That’s the lowest 6-month forward SPX IV since late February of this year. However, 20% IV for 6-month SPX options is still historically high.

Similarly, Russell 2000 (RUT) 180-day IVs have fallen to multi-month lows. Goldman Sachs’ Jake Glasser points out that 3-month skew in the small caps is now measuring at the lowest levels since late 2018.

Many investors think in annual terms. Earlier this year, we highlighted another natural inclination – evaluation of data over specific time horizons. That’s in part why term structure plays such an important role in macro volatility trading. While many traders focus their attention on the front of the volatility curve, there’s meaningful information to be gleaned when we look further out in time.

An evaluation of Cboe's S&P 500 One-Year Volatility Index going back to 2016 illuminates how unusual this year has been. This Index applies the VIX methodology and uses S&P 500 options with approximately 365 days until maturity. Long dated Index option vol tends to be more stable than shorter dated expiries. As you can see below, one-year expected volatility for the S&P 500 had vacillated above and below the 20% level for years…until February. 

Source: Cboe Global Markets 

The novel coronavirus altered everything from your daily commute and grocery shopping to global GDP and the long end of the SPX vol surface. Since the beginning of the pandemic in the States, one-year expected SPX volatility has remained mostly between 30-40%. The highest ever close for VIX1Y was 52.78 on November 20, 2008. Comparing that to March 18 of this year, VIX1Y closed at 45.86 and measured as high as 50.60. Since the acute phase of the equity selloff, the low close for VIX1Y occurred on June 5 at 27.47. Last week (11/9) the constant one-year forward vol measure settled at 27.83.

It will be interesting to see if long dated Index volatility measures continue to attenuate as we move into year-end. We’ve heard all too often, past performance is not indicative of future results, but typically the Thanksgiving and December Holiday period tends to be strong for equities, putting pressure on IV levels.

In effect, the “investment fog” that we alluded to in the previous volatility piece may be receding. The electoral miasma is dissipating. The prospect of a scientific breakthrough in the battle against COVID-19 appears to be on the horizon. This triad of tailwinds also includes the likelihood of a divided U.S. government, which business and the market tends to favor.

It’s sort of an unspoken rule

That things would not turn out the way we planned

You know that I can handle all of that

If I admit that I was wrong

So now what?

-The Shins So Now What




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