Inside Volatility Trading: Sometimes, Smaller is Better

Kevin Davitt
March 15, 2022

Some goin’ east, some goin’ west

Some stand aside to do their very best

Some livin’ big, but the most livin’ small

Peter Tosh – Stop That Train

Is Bigger Better?

Humans have an evolutionary desire for “more.” Hunter-gatherer societies were nomadic and constantly searching for sustenance. “More” was associated with greater probability of survival. For example, a larger buffalo was objectively better because it would yield more meat, more skin – a lot more. From an economic standpoint, more… was better. 

Source: FreePik

While our daily lives look way different than those of the Paleolithic era, our minds are quite similar. We’ve maintained the desire for more, even though it’s often unnecessary. From cars to calories and other creature comforts, more isn’t all it’s cracked up to be. The law of diminishing marginal utility has an inflection point. Basically, there can be negative utility for consumption beyond a specific point. Unlike pizza and paychecks, bigger isn’t always better. 

Thinking about the capital markets, is bigger always better? A larger portfolio, greater opportunities, big gains… they all sound great to me. Perhaps it’s my Neanderthal brain at work because it ignores the interconnected relationship between risk and reward. The question is not so straight forward.

Derivative markets, like any other market, have embedded financial risk. The magnitude of risk in derivatives is related to the notional value embedded in the product. That goes for other markets as well, but we don’t typically use the term “notional value” to quantify the risk. In consumer transactions, the price you pay tends to correspond to the degree of risk or responsibility. For example, most might agree there’s more risk in the decision to buy a million-dollar home than there is to rent an apartment for $1,500 per month. 

To be clear, we’re talking about financial risk. I could get a Portillo’s Big Beef (dipped, of course) with giardiniera, a large order of fries, and milkshake for about $15. The risk there is my longer-term health given that bag of take-away contains around 2,500 calories. That’s one delicious risk, but I digress (and digest). How does this play out in capital markets?

The S&P 500 Index was measuring around 4400 in early March. A standard SPX option has a contract multiplier of 100. Every SPX option affords exposure to 100 units of an index that, at that time, was measuring 4400. So, the notional value (Index value * Contract multiplier) of every SPX option would have been ~$440,000.

On average, nearly 1.6 million SPX options trade daily. Based on volume alone, the SPX options clearly have utility. Generally, they’re used by individuals and institutions with larger portfolio values looking to manage risk. If my portfolio is substantial, diversified, and behaves like the S&P 500 Index, I may choose to use SPX options to hedge my risk or express a market view. 

What about the rest of us who might be new to the option markets? What if my portfolio value is smaller? What if someone wants exposure to the S&P 500 Index, but the size of the SPX contract is just too dang large?

Appropriate Size Matters

Nanos are here! Cboe is excited to introduce a smaller, simpler index option product.

Nanos work very much like regular index options, but, recalling the relationship between price and risk, a single Nanos contract is much more affordable. Let’s explore why.

The underlying index tracks the performance of the S&P 500 Index. However, the Nanos index is 1/10th the size of the standard S&P 500 index.[1] Assume the S&P 500 Index is measuring around 4400. Since the underlying index for Nanos is 1/10th the value of the S&P 500 Index , the Nanos index would be measuring ~440 (4400/10). Translation, it’s much smaller.

There’s another key difference between a Nanos contract and a standard index option contract. Nanos have a 1-multiplier whereas all standard equity and index options have a 100-multiplier. Leveraging our example from above with the S&P 500 Index at 4400, Nanos have a more digestible notional value of $440 (Index level * Contract multiplier).

An example comparing equivalent (ATM) options will reinforce this important multiplier difference. Assume again the S&P 500 Index is valued at 4400. Suppose the ATM (4400 strike) call option in the SPX with two days until expiration has a mid-market value of 30.00. Remember SPX options have a 100-contract multiplier, so I would need $3000 (30.00*100) to buy that option (plus applicable fees and commissions).

Suppose in comparison the ATM (440 strike) call option in Nanos has a mid-market value of 3.00 (smaller, 1/10th index). Given Nanos has a 1-multiplier, I need just $3 (plus applicable fees and commissions) to buy that option. Though both options afford me upside exposure to the S&P 500 Index over the next two days, Nanos are simply more affordable.

For additional simplicity, there are far fewer strike prices listed for Nanos. Many newer market participants tend to be overwhelmed by the number of strike prices available for standard index options. In each expiration of SPX options, there can be +1000 total strikes. At any given time, there will only be a handful of strikes listed for Nanos.

Imagine a cereal aisle – did you know there are at least sixteen versions of Cheerios? I’m a fan of the classic and Honey Nut varieties. Sometimes you just don’t need too many choices.

Nanos are a great option for options traders (pun intended!), and to further help newer retail investors wrap their heads around ‘em, Cboe is relaunching our very own Options Institute. The OI is packed full of learning resources; take a peek here: The Options Institute

Weeklys: Leading by Example

Cboe has a history of anticipating and responding to shifts in demand. For example, when the exchange listed equity options in 1973. Index options were pioneered in the early 1980s, followed by long-term options (LEAPS®) in 1990, and the VIX Index in 1993. VIX futures and options arrived in 2004/2006, respectively. In between those last two monumental innovations, Cboe was the first exchange to list Weeklys in 2005.

In 2005, the initial reaction by the trading community to options that expire weekly was tepid. Many market participants didn’t see the potential appeal in options with short-dated maturities. But that viewpoint overlooked two drivers of success for Weeklys – they have lower premiums when compared to options that expire further out in time, plus they allow for more specific exposure.

Let’s imagine I’m keenly interested in next month’s jobs data (Nonfarm payrolls). Remember, that information is released on the first Friday of the month. Prior to the introduction of Weeklys, the most proximate expiry would have fourteen more calendar days until expiration. Since 2005, I’ve been able to use options that expire the same day as the monthly jobs data is released. Those weekly options have a smaller premium than the same strike that expires two weeks later, a nice benefit if I’m a buyer. The option that expires in one week will be cheaper (in dollar terms) than the same one expiring in three weeks. My total risk is smaller as a result.

Comparatively, if I’m more interested in selling options, time decay (theta) occurs most rapidly in the week ahead of expiration. I have the potential to realize theta more quickly and more often. Both alternatives are compelling but have very different risks to be aware of.

Volume Trend

Over the past few years, options volume continues to move toward short-dated maturities and smaller average contract size. Let’s visualize that trend to see what that means.

Option Volume by Maturity

Source: Cboe LiveVol Pro

The graph plots annual volumes (as a percent of total market share) on the Y-axis. Days until expiration are laid out on the X-axis. Let’s focus on options with one day until expiration. In 2016, roughly 5% of all options traded had a single day until expiration. In 2021, that figure grew to 11%.

Last year nearly 10% of all options traded expired the same day and more than 20% of all options traded expired in 24 hours or less. Even the biggest proponents of Weekly options in 2005 likely couldn’t have imagined how successful these products would become.

The Growth of Individual Trading

There’s been a lot of media attention on the growth of retail/individual trading over the past two years. The confluence of coronavirus lockdowns, stimulus checks, and ease of market access (Robinhood, etc.) introduced millions to the capital markets since early 2020. On average these people are younger (mid-30s), have fewer investable assets and higher risk tolerances relative to older investors.

Over the same time frame, average daily volume in US option markets skyrocketed. Going back to our “notional value” concept, by May 2021, the notional value of daily options trading exceeded the notional value of daily equity trading. Compare that to 2020, when on average about $100 billion in notional options trading occurred daily and about $240 billion in notional equities hit the tape. The value of daily options trading increased five-fold between early 2019 and late 2021.

Value of Daily Options Trading (2019-2021)

Source: Cboe Global Markets

To give the growth rate even greater context, let’s look at average daily volumes in equity options over a longer time. Twenty years ago, on average about two million equity options traded daily. In 2021, daily volumes approached 38 million and this year the average is running 43 million. The chart below shows the massive growth since 2018 (volume in millions).

U.S. Equity Options ADV (2000-2021)

Source: The OCC & Cboe Global Markets

You can see the pace of option volume growth picked up following Cboe’s launch of Weeklys in 2005. The growth since the industry moved to (mostly) commission-free is even more demonstrable. We’re excited to see the degree to which Nanos growth resembles Cboe’s other game-changing innovations.

VIX Backwardation

As excited as we are about the Nanos launch, it wouldn’t be an Inside Volatility newsletter without some exploration of VIX!

VIX Backwardation Graph (October 2020-Present)

Source: Bloomberg

The snazzy visual here plots the relationship between the front month (standard) VIX futures contract and the second (standard) future. Going back to October 2020, the chart highlights the handful of occasions when the front month (standard) future traded at a premium to the second month contract. Those periods fall above the red horizontal line. That’s when the VIX term structure is backwardated or inverted.

Inverted term structures are unusual, and in the case of VIX, indicate meaningful concern about future volatility. There’s already been far more days in 2022 (twenty-two as of March 10) where the VIX term structure closed in backwardation compared to all of 2021 (happened twice). In fact, it’s the longest VIX inversion since the COVID-selloff of two years ago.

Equity, commodity, and volatility markets continue to grapple with the potential impact of Russia’s decision to send troops into Ukraine. The inversion in VIX and the significant rise in energy prices reflect the ongoing concern. 

Learning How to Learn

I’m a father of an awesome seven-year-old boy. It’s incredible to see a young person develop and learn new things. He’s now reading and writing and expressing himself in profoundly different ways when compared to a year or two ago. I am reminded that learning requires a foundation. You start small and build upon fundamentals.

Some examples: I’ve been coaching his youth baseball team. Boys and girls with varying degrees of exposure to sports have all made huge strides because we focus on the basics. Initially very few children understood the equipment, rules, and positions, but it’s reinforced week after week. The practice inspires the growth.

The “start-small process” plays out across endeavors.

Richard Dennis was an order runner on a Chicago trading floor as a teenager. By his early 20’s he started trading “mini” commodity contracts. The legend has it he turned less than $2,000 into a few hundred million before he was 27. Start small, grow…big.

You can’t start at the finish. Despite our desire for more, bigger, better -- there’s no substitute for starting small, learning from mistakes, and improving. The approach allows for the flexibility to course correct and carry on – in baseball, in options trading, in life. So, happy birthday to Nanos – the new, smaller, simpler options contract available for trading beginning March 14.

Our prehistoric minds might want “more,” but it’s important to understand that risk (and potential reward) increase in unison. Sometimes, smaller is better. 

Industry News



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[1]            Nanos trade on Cboe as a $1 multiplier option (versus a $100 multiplier for standard options) on the Mini- S&P 500 Index, which is 1/10th the value of the S&P 500 Index.