Cboe Global Markets

Inside Volatility Trading: The Chicken or the Egg?

Kevin Davitt
April 20, 2021

This brave new world

It’s gonna take some getting used to…

It’s unusual

Except now it happens all the time…

Typhoon – Unusual

Sentiment (Chicken or the Egg Conundrum)

The “Chicken-and-Egg” metaphor is an elegant inquiry into cause and effect. Humans have evolved and occupy a dominant place in the biological ecosystem, largely from their ability to cooperate as well as discern and manage relationships. Potential threats to well-being typically caught the attention of those that understood the correlation between (for example) large animals stirring in ancient Mesopotamia and the prospect of being attacked. The cause and effects were clear.

Survival was and is paramount.

Action. Reaction.

We constantly (re)evaluate our surroundings for threats. We have highly developed senses that alert us to subtle changes in the environment. Investors and traders rely on similar, yet distinct market signals that inform their decisions. Those decisions (actions and reactions) are typically analyzed based on outcome (profit and loss) and are ideally sharpened over time.

So, what came first, the chicken or the egg?

Market signals can become “Chicken-and-Egg” scenarios. We can evaluate historical inflection points, point to various data points and perhaps discern some cause and effect relationship. Does that mean the next time a historical source of volatility emerges the outcome will be similar? Not necessarily.

Market sentiment is an expression of the mood of financial market participants. It’s an aggregate opinion poll that attempts to distill psychology into a number. If you can’t measure it, you can’t manage it. Or can you?

There is a plethora of market sentiment measures. Here’s a list that is by no means exhaustive:

  • AAII Bullish/Bearish
  • Wall Street Strategist Asset Allocation
  • NAAIM Survey of Investment Managers
  • University of Michigan Consumer Confidence
  • NFIB Small Business Optimism
  • Advance/Decline Ratio
  • New High/New Low Ratio
  • TRIN
  • Rydex Ratio
  • Money Market Levels
  • NYSE Margin Debt Levels
  • Put/Call Ratios
  • Open Interest Ratio
  • Stock/Bond Ratio
  • Smart Money Index
  • Credit Default Swap Index
  • CSFB Fear Barometer

Despite significant “competition” in the sentiment arena, the VIX® Index still is the bellwether market sentiment measure for many market participants. The VIX Index tends to be the most frequently cited in the media. The fact that it’s constantly looking forward and based on current prices (supply and demand drive prices) makes the VIX Index profoundly valuable.

The utility of sentiment polls (or polls in general) has been called into question over the past decade. Biases are ever present and there’s a tendency for people to say one thing and do another when the stakes are low (polling is low stakes). We tend to tell people what they expect to hear or what others are saying. Following the crowd has historically had benefits.

By contrast, when we “vote” with our wallets, the truth typically emerges. In other words, when money is involved, the resulting data tends to be more veracious. The VIX Index is derived from current S&P 500 Index option prices that expire between 23 and 37 days in the future. 

Do sentiment measures drive price or vice versa?

Markets are fascinating on so many levels. From a panoramic perspective, investors tend to be most excited about buying when markets are at or near highs. The same investors tend to be most despondent and likely to sell when markets are at or near lows.

Investor Emotions During Market Cycles

Source: Delaware Funds + Cboe Options Institute 

Related, but different, protection measured in terms of implied volatility for options tends to be “cheapest” (low) when markets are at or near highs and vice versa. The adage on derivative trading floors was “buy insurance when you can, not when you have to.” The demand for insurance typically skyrockets when the proverbial house is on fire. Consequently, the price for protection tends to increase exponentially.

This likely comes as no surprise to veteran option traders or long-time investors but the persistence is interesting. Is “insurance” cheap now? Maybe so, maybe not.

An argument could be made that price is the ultimate sentiment driver. Let’s look at a couple of examples.

Residential real estate has been hot. The National Association of Home Builders (NAHB) Housing Market Index is just off all-time highs. Inventories are low and demand has been consistently strong. Prices (on average) have been rising at a rate last seen in 2006 (11.2% year-over-year).

Is the prevailing sentiment in the real estate market driven by low interest rates? The supply/demand dynamic? The desire for more space after stay-at-home orders? Almost certainly yes to all of them but price is the ultimate arbiter. At some point, price rations demand.

The current sentiment in housing is arguably a reflection of prices moving higher. If/when prices change, so too will sentiment.

Now, think about last January and February in global equity markets. People were aware that a novel virus was spreading as early as late 2019. On January 3, 2020, Robert Redfield (head of Centers for Disease Control and Prevention) and Alex Azar (cabinet member) were cognizant of a viral threat that was spreading. By January 10, the genome for the new virus became public. The following day was the first confirmed fatality from COVID-19. 

  • January 13: First known case in the United States (Chicago resident who had travelled to Wuhan, China).
  • January 17: German researchers develop the first COVID-19 test.
  • By the middle of January, it was clear that the virus was spreading from human-to-human transmission. The World Health Organization (WHO) put out recommendation on how to protect yourself.
  • January 23: 11 million Chinese residents of Wuhan are placed under quarantine.
  • January 30: WHO declares the outbreak “a public health emergency of international concern.”
  • January 31: Travel restrictions placed on China (to the United States).

By the beginning of February, more than 10,000 cases were confirmed. Asymptomatic transmission was known. The threat to potentially 1 million American lives was documented in a memorandum from the New England Journal of Medicine.

Between January 31 and February 19 of last year, the S&P 500 Index moved from 3,225 up to 3,386. In other words, the broad-based U.S. market moved higher by 5.0%. On February 19, more than 75,000 global cases were confirmed, over 2,000 had died (including Li Wenliang, aged 33, the Chinese doctor who first warned about the disease), and prices for many equities continued to advance. Until they didn’t.

Five weeks later, on March 23, the S&P 500 Index had declined by 34%. The index moved from just below 3,400 to 2,237. By that point, a global pandemic had been declared, nine U.S. states were on lockdown, nearly 380,000 global cases were confirmed and the death toll was approaching 17,000.

Things looked bleak. Sentiment in capital markets was despondent. The VIX Index had closed above 82 days prior, which exceeded any level from the 2008 Global Financial Crisis. Then equity prices started to rise. The S&P 500 Index bottomed.

Prices changed. So too did sentiment.

You could make an argument that sentiment changed after the VIX peak on March 16 when “prices” for S&P 500 Index options began to decline in volatility terms. The broad market bottomed days later and the rest has been a historic bull-run. 

Here & Now

On April 8, the VIX Index closed below 17 for the first time since February 20, 2020. The index has remained below 17 (closing basis) for a week. Both realized and implied volatility levels are moving back into “normal” ranges. The relative cost of protection, in the form of index options, continues to decline. For example, the 3-month (July standard S&P 500 Index) 90% moneyness puts are trading on a 23% implied volatility.

Do you feel more, or less inclined to use index options to potentially insulate against future volatility (downside) given the decline in relative price?

Is sentiment driving price or vice versa?

There was media coverage following the recent (4/8/21) July VIX Index call spread that printed in size. Over the course of a session, roughly 200,000 of the July 25/40 call spreads were purchased with a July VIX futures reference around 23.10. The slightly OTM call spreads mostly traded for ~2.00, so the premium outlay was roughly $40M. The July VIX options have just over three months until expiration.

Given the size and notional value of this position, it’s likely a hedge against the prospect of higher implied volatility that’s balanced by significant long equity exposure. Based on a 2.00 execution and 15.00 wide call spread, the most the trade could make at expiration is 13.00 or $1300/spread. Considering the size of the spread (200k), that works out to a potential “profit” of ~$260M (not including frictional costs). VIX options cash settle at expiration.

So, hypothetically, if I managed a portfolio worth $1 billion with a beta close to 1.0 (behaves like the S&P 500 Index) and was concerned about a 20% drawdown in the next three months, perhaps I would use VIX options to offset some portion of that risk. My thesis presupposes that if the S&P 500 Index fell by 20% around mid-July, that the VIX Index and related futures would likely be trading significantly higher.

If the S&P 500 Index declined from ~4100 to ~3300, my equity portfolio would be worth about $800M (down about 20%). If the VIX options spread was held, and the July VIX futures expired anywhere above 40, the profits from the hedge position ($260M) would more than offset the drawdown in my equity portfolio. In fact, the total portfolio would be up 6% in that scenario.

In the event the S&P 500 Index was unchanged and the VIX options went out worthless, the portfolio would be down 4%. The worst-case scenario would be an S&P 500 Index decline that didn’t move the July VIX futures over 25 by expiration. In that case, the equity portion of the portfolio is losing, and the hedge is also a drag.

Looking back at the past 12 VIX Index expiries, the average level works out to 26.45. The highest VIX Index expiration value was last April at 42.51. The lowest was March of 2021 at 20.80. Is the trend highlighted below likely to change in the coming months?

VIX Index Expirations Between March 2020 and April 2021

Source: Cboe Global Markets

Recent research from Hussman Advisors quotes former President Jimmy Carter and the late economist and public intellectual, John Kenneth Galbraith:

“There always seemed to be a need for reckoning in early days. What came in equaled what went out like oscillating ocean waves”. – Carter

“There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present”. - Galbraith

The piece centers on the idea of valuation (not price) and it’s worth the read. John Hussman, PhD is a polymath with deep knowledge and experience in the derivatives markets. Some dismiss him as a “perma-bear” but his funds’ performance into and out of the dot-com bubble and the global financial crisis was exceptional.

His latest missive touches on persistently low rates, margin debt levels, growth forecasts, price-to-earnings (P/E) and price to sales ratios with a core focus on current valuations and the prospect for a lost decade in capital markets.

Based on their current models, they forecast negative annual returns for the S&P 500 Index over the next 10 years. The alternatives (government/corporate debt and utilities) have slightly positive, albeit paltry prospects. In short, their long-term view is worse than it was in March of 2000 or October of 2007. According to Hussman, “all measures correlated 0.89 or higher with actual subsequent returns since 1950.” The glass, as they say, is (possibly) far less than half full.

Correlation of Projected Nominal Total Return Estimates with Actual Subsequent Returns since 1950

Source: Hussman Research

“When a good market valuation measure rises, the extra return you celebrate has simply been removed from the future. When a good market valuation measure collapses, the shortfall of return that you suffer has also been added to the future. It’s important to know where you stand in that cycle.” - Hussman

Prices will continue to change. The prevailing sentiment is far rosier than it was a year ago. In fairness, the future seems much less opaque than it has for many months. Current prices arguably reflect that translucent outlook.

Quarter one (Q1) 2021 portfolio numbers likely look far better than Q1 2020. Check the mail or logon and see. Is your sentiment tethered to that bottom-line figure or an expectation that things will continue to improve? Is it price sensitive? Valuation sensitive? What drives your sentiment?

If you’re concerned, are you proactively using financial tools to manage future uncertainty?

Or will you wait for the prevailing sentiment to change first and where will prices be then?

There is no holy grail. There are no infallible tools. There are no perfect models. There is a tremendous amount of data. That output impacts the prevailing psychology and future decisions (i.e. prices) are the purest reflection. Price and value are two distinct things. Prices are determined by the “marginal buyer.” Prices are transient. Value is durable.

…Now the truth is immaterial:

Every teller’s got an axe to grind

Typhoon – Unusual

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