Cboe Global Markets

Inside Volatility Trading: Volatility Spreads Alongside COVID-19 Fears

Kevin Davitt
March 11, 2020

“And as you rise above

The fear-lines in his brow

You look down

Hear the sound

Of the faces in the crowd”

Source: Fearless: Gilmour/Waters

It’s difficult to strike an appropriate chord when analyzing and educating interested parties about volatility in the current environment.

If “a picture says a thousand words” then the word count for this Inside Volatility Newsletter will come in between David Foster Wallace’s magnum opus, Infinite Jest (543,709 words) and Marcel Proust’s In Search of Lost Time (1,267,069 words).

For reference, the charts/data were pulled the afternoon of March 6. This is a very fluid market. Sentiment can shift meaningfully over the course of a few hours. It is important to keep this in mind during times like these. Maintaining perspective when markets move with the velocity they have over the past two weeks can be very difficult.

To wit, the 9-day average true range for S&P 500 futures has been 115 handles. The 14-day average true range is 98 handles. Over the past two weeks of trading, the average 1-day move in the S&P 500 has been +/-2.8%.

A true range indicator takes into account the absolute value of daily high-to-low ranges. Historical volatility measures, which we’ll look at momentarily, have also been very high, but are calculated on a close-over-close basis and will temper an analysis of actual intraday moves.

Now let’s turn our focus to the visuals, including brief interpretations.

Source: Bloomberg

SPX 10-day realized vols are running at 53.7% and the 30-day is up to 32.1%. Those are both at their highest levels since late summer of 2011. At that point the 10-day SPX HV reached 66.8% and the 30-day level nearly touched 45%. As a reminder, late 2011 was the last period of persistent macro volatility. Global markets were roiling on headlines related to European Sovereign debt (PIIGS), the very real possibility of a Greek default. Fears were exacerbated when Standard & Poor’s (credit rating agency) downgraded U.S. debt from AAA to AA+ for the first time ever (August 5, 2011).

Source: Bloomberg

The VIX Index has pushed into the 50s in recent days. The last time the VIX Index saw closes close to 50 was 11 years ago on March 9, 2009 when the VIX index closed at 49.68. That date also marked “the bottom” for the broad market. The S&P 500® measured below 670 on the session and closed the year (2009) around 1120.

Interestingly, or perhaps appropriately, a VIX Index at 48.00 forecasts daily SPX moves of +/-3%. As mentioned above, the market has been moving at roughly that rate over the last two weeks. As a rule of thumb:

VIX Index ~16 = 1% daily SPX moves

VIX Index ~32 = 2% daily SPX moves

VIX Index ~48 = 3% daily SPX moves

VIX Index ~64 = 4% daily SPX moves

252 trading days in a year. The square root of that time frame = 16.

Interest rates in the U.S. and globally have plummeted in recent weeks. On the 3rd of March the Federal Reserve held an emergency meeting and reduced the Fed Funds rate by 50 basis points. This was the first emergency (non-scheduled FOMC meeting date) action on the part of the Fed since October 8, 2008. There were a total of 3 unscheduled rate cuts during the height of the 2007/2008 financial crisis.

Prior to that time period, you must go back to the late 1990s and early-Aughts for emergency Fed cuts.

10/15/1998: Russian default and Long Term Capital Management implosion

1/2/2001; 4/18/2001; 9/17/2001: Economic slowdown following dot com bust as well as September 11th attacks on New York, Washington D.C. and in Pennsylvania.

In short, the recent market activity from equities to bonds and volatility are unusual from a historical perspective.

Source: Bloomberg

Moving back to VIX Index, but this time taking a look at the futures market:

As a reminder, the VIX Index measures, but it’s not tradable. VIX futures and options are actively traded and volume of late has been incredibly robust.

One indication of stress, or lack thereof, in the equity markets is the VIX term structure. The current inversion (backwardation) in the VIX term structure is the most meaningful since the sharp selloff from late January 2018 (all-time highs) to February (2018) lows. From peak to trough the S&P 500 declined by 11.9% in short order.

Source: Bloomberg

On March 6, the month 1-month 2 VIX spread moved out to 6.85 wide. The spread traded slightly wider in the middle of February 2018 as well as during the zenith of the European Sovereign debt crisis. This is perhaps another indication that we are in unusual, but not unprecedented territory.

Moving now to the outright front month VIX futures, here’s a chart that shows the lead month (rolling) back to 2011. The March VIX futures (VXH0) traded as high as 40.15 on Friday. That’s the highest print for a front month VIX future since the October 3, 2011 settle at 45.05.

Source: Bloomberg

It remains to be seen whether the broad market is nearing support, but in 2011 the S&P 500 found a bottom on October 4 after a 19.4% drawdown. That selloff occurred over 157 calendar days. The current “correction” has shaved 14.5% off the top since February 19th. That was 16 calendar days ago.*

Reminder: You don’t own insurance with the hope that you find out how it works, but you’re grateful when an unforeseen event occurs and you have the policy. Hedges have fallen out of fashion in large part because they have been a performance drag for the better part of the last decade. That sentiment and efficacy has perhaps shifted over the past year or so. Something to keep an eye on.

*All data as of Friday March 6, 2020

“You pick the place and I’ll choose the time

And I’ll climb the hill in my own way

Just wait a while for the right day…..”



Video - Highest VIX Index Close Since Last Recession

Q: The Fed made an unexpected rate cut this week. What impact, if any does that have on option prices?

- Brian (Austin, TX)

That’s a really good question and one that’s not asked as often as it was years ago – when rates were significantly higher.

A: There are at least 5 or 6 inputs to each option pricing model. Not all equities or ETFs pay a dividend. While we’re at it – NO Indexes pay a dividend. That’s an important thing to consider when trading derivative products.

Now, interest rates impact nearly everything in life. Most directly, fed funds impacts the cost of short-term financing. More specifically, it’s the interest rate at which banks and other depository institutions will lend to one another at overnight. Institutions with surplus reserves will lend those funds to other institutions on an uncollateralized basis.

Lower fed funds may have a knock on effect for longer term rates that impact the borrow costs for things like cars, homes, or credit card balances. Interest rates also impact the “cost of carry” for stocks, which has an impact on derivative values.

Put Call parity dictates that a portfolio of a long call and short put with the same strike and expiry will behave like the underlying (synthetic) security. The options, therefore, need to price in future dividends and the cost associated with owning (or being short) the stock until expiration.

In options, those two factors, dividends and interest are considered the “cost of carry.”

Rho is the theoretical change in value of an option for every 1% (100 basis point) change in the risk free rate.

All else equal, call option values will increase when rates go up and decrease when rates move lower. Longer dated options (LEAPS in particular) are much more sensitive to changes in rates than short-dated options.

All else equal, put option values will decline when interest rates rise and increase when the risk free rate declines.

Thanks for the question and feel free to ask anything related to derivatives or volatility to [email protected].