Inside Volatility Trading: The Adventures of Volatility Markets

Kevin Davitt
June 29, 2021

The Adventures of Volatility Markets

Samuel Longhorne Clemens, better known as Mark Twain, has been called “the father of American Literature” (William Faulkner). Twain was a public intellectual and successful author. As such, he’s become one of the most (mis)quoted writers/speakers of all time. One frequently mangled missive from June 1897 addressed rumors that he had died:

I have even heard on good authority that I was dead. The report of my illness grew out of his [Twain’s cousin] illness. The report of my death was an exaggeration.”

I was reminded of Twain’s humorous take when I noticed a tweet from Benn Eifert. For the past few years, market pundits have predicted the demise of option-based volatility selling strategies. In other words, rumors of the death of the “short-vol” trade have been greatly exaggerated.

Exhibit 1A: AUM of Public Funds (Mutual Funds, ETFs, CEFs) in Option Selling Strategies

Source: Dr. Benn “DJ D-Vol” Eifer, @bennpeifert

There have been short volatility traders throughout history and certainly since 1973 when listed options were introduced. Historically short vol positions were structured using over the counter (OTC) products like volatility or variance swaps. Cboe® altered the volatility landscape in 2004/2006 when VIX® futures and VIX® options were launched. Tradeable VIX products brought much of the same exposure from the opaque OTC market into the listed, transparent markets. Based on Benn’s chart, the short vol trade is still alive and well.

While there are a wide variety of potential approaches, managing short volatility positions carries very significant risk. Volatility measures (realized and implied) can change dramatically and with no real warning. Based on historical data, half of the largest close-over-close moves in the VIX Index have occurred since 2018. For perspective, VIX data goes back to 1990. 

Ten Biggest Close-to-Close VIX Spikes


Going back to the first visual, the blue line tracks the assets under management (AUM) for mutual funds, ETF’s and Closed End Funds that engage in option-selling strategies. The green line plots the total number of funds employing those approaches.

There are a couple of things that stand out. The number of funds utilizing short volatility positions began to grow following the 2008 Global Financial Crisis. In 2012, after the European Sovereign Debt Crises, there was another change in trajectory with far more firms engaged in short vol strategies.

The average VIX Index level in 2008 was 32.7 (the highest to-date). Full year 2020 comes in third (behind 2008 and 2009) with an average VIX Index measuring 29.25. From my perspective, it stands to reason that short volatility strategies often postdate periods of significant macro volatility. 

The insurance business is, in many ways, analogous to managing short volatility exposure. In theory, selling “insurance” when premiums (the cost of protection) are historically high would be opportunistic. However, it’s important to note that insurance firms do not just warehouse all the risk associated with their underwritten policies. Like many option traders, insurance companies will offset their exposure in other (reinsurance/etc.) markets.

Turning attention to the growth in AUM, there’s clearly a shift in flows around 2013. I want to respect the important distinction between causation and correlation. An argument could be made that Quantitative Easing (QE) programs became analgesic for macro volatility.

Yardeni Research has a comprehensive chronology of FOMC QE dates/decisions. QE3 was initiated in early January 2013. Even though the Fed “tapered” that program in December of the same year, there was a paradigm shift on the part of many investors. A religious-type faith in “the Fed put” (or implicit protection against large drawdowns in asset values) took hold in many circles.

Risk vs. Potential Reward

Low interest rates incentivize a move out the risk spectrum. The onset of a “zero interest rate” environment made many fixed income product’s yields unattractive. The prospect of potentially generating yield from option writing strategies (riskier) became widely embraced. Equity market volatility receded.

Between January 2013 and the end of February 2020, 12-month S&P 500 Index realized volatility never moved above 17.5%. The average for that period was 12.66%. For full year 2017, the average was a paltry 8.94%. Against that type of backdrop, most short option premium strategies will be successful. That success can breed confidence and become a “virtuous” cycle.

Until the cycle ends.

The significant jump in realized volatility in February 2018 and the persistent volatility that characterized 2020 (red circles in example 1A) led to losses in short vol strategies and drawdowns in AUM. The number of funds actively selling volatility flattened out last year, but the AUM figures have grown as volatility abates. 12-month S&P 500 Index realized volatility levels have declined to 15.9% and 1-month measures are now around 7.2%.

The visual below plots S&P 500 Index 1-month realized volatility over the past five years. The callouts corresponding to significant increases in realized vol show the respective drawdowns in the S&P 500 Index.

S&P 500 Index 1-Month Realized Volatility

Source: S&P Global

Here & Now

“Stars and shadows ain’t good to see by.”The Adventures of Huckleberry Finn

We’re very near the end of Q2. You will likely receive a quarterly statement for some of your accounts soon. Related, many asset managers are benchmarked based on their quarterly performance relative to the market. Below is a breakdown of how the most actively traded U.S. commodities (including equity indexes) have performed in Q2 and year-to-date (YTD).

The S&P 500 Index hasn’t suffered a 5% peak-to-trough drawdown since late October 2020, just before most recent U.S. elections. In VIX terms, the story is the same across time horizons: expected volatility for the S&P 500 Index is lower.

Commodities Performance: Q2 2021 vs. YTD 2021


Some brief highlights for a noisy visual:

  • Energy prices are higher this year and over the past quarter.
  • YTD, ethanol and gasoline futures lead the pack.
  • On a quarterly basis, ethanol and natural gas futures top the board.
  • WTI crude oil has gained 50% in 2021.
  • Gasoline futures are higher by nearly 56%.
  • Lumber futures are up 30% this year even though July lumber is 50% off the early May contract (all-time) highs.

Bond futures are lower (yields higher). Inflationary narratives have dominated the financial press in recent weeks. Consumers are paying more for many goods and services relative to the end of last year or the middle of 2020. The Federal Reserve has doubled their balance sheet over the past year. In March of last year, they held ~$4 trillion in assets. The pace of their asset purchases has continued as the economy normalizes and, as of last week, their balance sheet held $8.06 trillion worth of securities.

While treasury yields have moved higher in 2021, they remain unusually low from a historical standpoint. There are interesting relationships between bond yields for assets with different risk profiles. The option-adjusted spread (OAS) is one approach market participants can use to compare relative rates. It’s arguably superior to just comparing yields to maturity considering many products have embedded optionality (callable) features. The OAS model “adjusts” for that “option” which many find valuable.

OAS of High Yield Credit and VIX Index

Source: St. Louis Fed & Cboe Global Markets

“All generalizations are false, including this one”Mark Twain

The visual above is the OAS spread for high yield credit with the VIX Index overlaid. The OAS spread data goes back to 1996 whereas VIX historical data runs from 1990. From my perspective, there’s a demonstrable butterfly effect in the VIX Index when high yield spreads widen.

The OAS spread has been grinding lower (alongside the VIX Index) and is currently at the lowest levels (3.15) since June of 2007. The all-time lows came in May of 2007 (2.46) just before reverberations in the subprime market started to spill over.

Rate spreads and the VIX could continue to narrow/decline. According to Fed Chair, Jerome Powell, the Fed remains committed to supporting the labor markets in the near term, but there is heighted concern about persistent inflationary pressures among the Fed voters. The “dot plot” (forward-looking) estimates for the Fed Funds rate now indicates the potential for two rate increases in 2023. The prior “consensus” was for no increase until 2024.

“Facts are stubborn, but statistics are more pliable” – Mark Twain

As it stands, rates are low and will likely remain relatively low for the foreseeable future. The “zero-interest rate” environment ostensibly incentivizes consumption and risk taking. Savers are penalized. Against this rate backdrop, leverage has become increasingly attractive. The zeitgeist of these times makes real estate investing, carry-trades, and speculation (on margin) potentially more attractive. The common hurdle for these endeavors is the interest rate risk, and that bar remains low.

The question (eventually) becomes…at what cost?

Margin Debt Relative to Nominal GDP

Source: NYSE/FINRA/Hussman Advisors

This visual plots Margin Debt levels compiled by the NYSE and FINRA relative to Nominal GDP in the U.S. The highlighted peaks (Sept ’87, Mar ’00, Jul ’07, and Jan ’18) are ominous from a potential future volatility standpoint. From my perspective, this data calls to mind the work of Thomas Piketty’s Capital in the 21st Century where the value of capital has been growing faster than the economy at large. Piketty argues in favor of a global wealth tax, which seems highly improbable.

In a related vein, following the recent G7 meeting, the prospect of a Global Corporate Minimum Tax appears to be gaining steam. In brief, the shifting of corporate profits, specifically the tax liabilities, to low or no tax countries (think: Ireland/Bermuda) may be far less beneficial.

Cboe’s SKEW®SM Index®SM

Volatility skew quantifies the relationship between OTM, out-of-the-money, (SPX) options in implied volatility terms. For example, you could compare the implied volatility levels for 5% OTM calls and puts with the same expiry. You could also compare similar options (10% OTM puts) with different maturities for more color. New to volatility skew? Take a look at this week’s Simply Put for a brief introduction.

Generally speaking, with equity index options, OTM puts command a higher implied volatility than equidistant OTM calls. Historically, markets tend to fall with greater velocity than they rise. September of 1987 redefined skewness in the options marketplace.

Cboe’s SKEW Index provides a glimpse into the demand for “tail risk” options. “When SKEW is equal to 100, the distribution of S&P 500 Index log-returns is normal, and the probability of returns two standard deviations below or above the mean is 4.6% (2.3% on either side).” When SKEW increases from 100 to 145 (currently it’s measuring around 160), the probability of a return two standard deviations below the mean jumps from 2.3% to 14.45%.”

SKEW adds another layer to the VIX Index. “VIX captures the first layer of perceived risk, as it tells how far on average the S&P 500 Index log-return is likely to stray on either side of its mean. SKEW catches the additional layer of risk implied by the left tail distribution.” (Cboe Skew Index – White Paper)

“Tom had discovered a great law of human action, without knowing it – namely, that in order to make a man or a boy covet a thing, it is only necessary to make the thing difficult to attain.” – The Adventures of Tom Sawyer

The cryptocurrency market has been home to significant volatility since its inception. The market capitalization for the global crypto market exceeded $2 trillion in early May. Since that point, the value of the overall market has been cut in half.

Over the last 100 days, the average annualized volatility for bitcoin is 90%. In mid-April, that measure was as low as 59%. On June 10, the same measure was 118%. Many traders gravitate toward volatile assets because they equate movement with opportunity. By contrast, investors traditionally shy away from markets with unusual volatility because of the perceived risk.

To date, the selloff in crypto markets have not spilled over into U.S. equities. That’s arguably evidence of crypto’s non-correlated tendencies.

“The average man (or woman) don’t like trouble and danger” – The Adventures of Huckleberry Finn

The S&P 500 Index continues to make new all-time highs. Home prices have followed suit and have made historic YoY advances. Core inflation readings are running at the hottest rate since the early 1990’s. The labor market is healing. In fact, job openings are at all-time highs. Corporate profit margins are just below their best levels ever. Junk bond yields are making new lows. COVID-19 infections in the United States are at the lowest levels since late March 2020 (when testing was not widespread).

There is much to celebrate.

Nevertheless, “It ain’t what you don’t know that gets you in trouble. It’s what you know for sure that just ain’t so.”

-Mark Twain

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