Inside Volatility Trading: Supply and Demand

Kevin Davitt
October 20, 2020

2020: The Clash

Should I stay or should I go now?

Should I stay or should I go now?

If I go there will be trouble

And if I stay it will be double

So ya gotta let me know

The Clash

 Markets are fundamentally driven by supply and demand. In general, a well-supplied market will push prices lower, all else constant, and vice versa. Derivative markets, particularly the implied volatility of option values, are reflective of the overall supply/demand dynamic at a given point in time. A shortage of supply typically pushes prices higher.

Source: Wikipedia

Implied volatility is the great unknown as far as option prices are concerned. Option pricing models are used to solve for what forward volatility the market is expecting based on the current value of the option.

In early 2020, the options market was expecting a presidential election (known unknown), which was reflected in index option values and the VIX® futures curve. At that time the market was NOT expecting a global pandemic and a massive shift in global GDP.

Initially the October VIX futures were the focus and the November cycle SPX® (or other index) options had the highest relative implied volatility levels. Here’s how the VIX futures curve was shaped on the first trading day of the year.

Source: LiveVol Pro

The obvious “kink” in the curve reflected the uncertainty the options market was pricing into November cycle SPX options and the October VIX futures contracts, which look forward 30 days from their expiration on October 21, 2020.

Since early September, protective demand has shifted further out in time. The November VIX futures and December cycle SPX options became the highest point for relative volatility on September 16. Keep in mind that VIX futures look FORWARD 30 days from their expiry which creates a relationship between VIX futures and the SPX options that expire a month later.

Source: Cboe

For passive investors and active traders the prospect of a prolonged electoral battle is concerning. If your trading thesis hinges on expectations for a decisive election outcome in early November, selling volatility into the known unknown may be attractive. A recent Bloomberg article (10/6) entitled “Election Volatility is Short Trade of a Lifetime for the Brave,” outlines varying perspectives on whether or not and why selling VIX futures or SPX downside protection makes sense given the future risks.

The historical tendency, according to Credit Suisse, is a post-election SPX change of 1.4%. As mentioned, implied volatility levels for options are backed out based on a pricing model. In a similar vein, forward volatility expectations can be calculated based on the difference between implied volatility (IV) levels at discrete points in time. An evaluation of the implied volatility of SPX options expiring just before and after the November 3 election date shows the options market is pricing in a potential move of 3.5% on the event. Nov. 2 expiring at-the-money SPX options are trading on a 19% IV. The Nov. 4 expiry options are trading with a 23% IV.

Looking at data from Trade Alert, there are a few interesting trading points during recent sessions. October 9 was the most active day for VIX options since September 3 (big-tech related selloff). On 9/3, VIX call traded volume was ~675k and the puts traded ~271k on the day. During the early September session, the VIX Index had a 10.28 H/L range. The S&P 500® declined by more than 3.5% on the day. Volatility levels were increasing and VIX calls traded far more actively than the puts.

By contrast, on October 9, the VIX Index vacillated in just over a 2-handle range. The S&P 500 Index advanced by 8/10ths of a percent. VIX call options traded ~275k and VIX put volume was ~567k. While there was very similar overall volume, VIX put trading dominated which could signal volatility traders positioning for a mean reverting vol market. In fairness, it’s also possible that traders were selling VIX puts into the move.

You have to go back to March 16 (82.69 VIX close – highest ever) for more active VIX put trading (610k).

On October 16, there were two sizeable VIX put ratio spreads. Based on pricing at the time of execution, it appears like a customer bought both the February and March 21/17 put 1x2 spreads. They paid 0.84 in both months.

These two spreads have identical P&L graphs at expiration, which will occur on Feb. and March 17 next year. If held through expiration, this trader would make money with a settlement between 20.16 and 13.84 for both the Feb and March VIX futures. The ideal scenario would be a 17.00 settle in both cycles.

Given the size of the position, each trade risks ~$5 million if held until expiration and the futures settle above 21. There is also risk in the event of a settle anywhere below 13.84. Each position could make just less than $19 million in the event of a 17.00 expiration settle. Note, this does not take into account frictional costs.

So, we have unusually high volatility being priced into derivative markets over the next two months. We also notice heavy VIX put trading in advance of the event. How do we potentially reconcile these two narratives? Are they related?

It’s debatable as to whether the VIX futures levels (and related SPX IVs in Nov/Dec) are more reflective of massive demand or simply a dearth of willing sellers.

More recently, we notice a VIX Index at or near the low end of its multi-month range (25ish). The lowest close for the VIX Index since the COVID-19 selloff occurred on August 17 (21.35). The October 9 close (25) was the lowest since August 28.

Are we headed back into the low 20s or teens on the VIX? Time will tell.

The S&P 500 Index got within 1.31% of its all-time closing high on October 12. 

The S&P 500 Index options market (SPX) continues to price the potential for consequential macro volatility in the coming months. That dynamic is reflected in the VIX futures term structure as well, but the entire curve has come in and flattened of late.

Another potentially interesting development of late is the relative performance of small-caps. Over the past month, the Russell 2000® Index is up 6.6% whereas the S&P 500 is higher by 2.42%. The spread between constant 30-day expected vols in the S&P 500 and the Russell 2000 have been narrowing.

Source: Bloomberg

The Russell 2000 Index (RUT℠) has far more domestic exposure (revenue/sales) than its large cap (S&P 500 Index) counterpart. The sector makeup also differs with healthcare, industrials, and financials making up the largest components of the RUT. By contrast, the S&P 500 sector exposure is very skewed toward information technology, with healthcare and consumer discretionary a distant second and third in terms of exposure.

Source: Siblis Research

Elections may beget very slight shifts in capital allocation or more meaningful deviations in flow. Changes in administrations, unified power versus division on Capitol Hill, and in some instances, the Supreme Court can bring about seismic variations in the appropriation of capital.

Following directly on the heels of the 2016 election, small-cap stocks experienced a dramatic outperformance into early 2017. It will be interesting to see if and how the major indexes perform in the weeks before and after this election.

Sell-side research (and others) have called attention to three critical catalysts going forward: stimulus, vaccine progress, and electoral uncertainty. Just one of those adjuvants (double entendre) would be enough to potentially move markets. The calendar dictates that they are running in concert. 

As we swing into earnings season and with the election now just two weeks away, the question becomes “should I stay or should I go now”? US equities have performed exceptionally well since the March lows. Technology has been the leader, but the S&P 500 and Russell 2000 are now only a few percentage points below old highs.

Depending on their thesis, market participants may choose to stay the course. Doing nothing is a choice. Others may engage hedging strategies in an effort to reduce specific portfolio risks over a given time horizon. The alternatives with respect to hedging are numerous, but Index options as well as VIX futures and options are two of the more direct ways to potentially mitigate unique risks.

November 3 may be just a “speed bump” of sorts. It could also catalyze another period of significant macro volatility. Our choices at the ballot box as well as in the markets have implications. Sometimes the two are related but understanding derivative tools and their flexibility may imbue greater control over these uncertainties.

We are all beholden to economic laws at some point. Our resources - individually and collectively are constrained. Volatility markets reflect this ebb and flow at various points in time. Implied volatility levels have been relatively high and shifting further out in time of late. We also always have choices and those decisions have consequences. There is important information signaled by derivative markets and well-informed market participants may use those tools as a means to an end.

Some shifts are short lived while other play out over a much longer time horizon. Are we approaching an epoch change? For those inclined to believe that the rally in US equities (tech specifically) is not only “long in the tooth,” but perhaps “very frothy,” here’s NYU Professor, Scott Galloway on Financial Crises & Asset Bubbles.

 We wrap with another Clash classic:

All the power’s in the hands

Of people rich enough to buy it

While we walk the street

Too chicken to even try it

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