Inside Volatility Trading: What's Moving the Markets?

Kevin Davitt
August 11, 2020

You got my heart, you got my soul

You got the silver, you got the gold

You got the diamonds, from the mine

Well that’s alright

It’ll buy some time

-The Rolling Stones “You’ve Got the Silver”

Cboe® is excited to announce the launch of the Mini Cboe Volatility Index (Mini VIX™) futures as of August 10. The Bloomberg ticker is VXLA. The smaller sized futures contract has a $100 multiplier as opposed to the $1000/point inherent in the standard contract. These contracts may allow for more precise allocation as well as flexibility for CTAs, sophisticated market participants, and those that understand volatility markets.

The domestic and global economies continue to grapple with the COVID-19 pandemic. In contrast, equity markets have been far more enthusiastic about the recovery.

As of August 6, the S&P 500® is within 1.5% of its all-time highs. The Nasdaq 100® Index (NDX) is 14% above its February 2020 highs. The broad market (S&P 500) has rallied 47% off the mid-March lows. The NDX is higher by 64%. The bull market in equities, particularly big tech, has been indefatigable for five months.

In a somewhat similar vein, Keith Richards has been alive and mostly well since late 1943. During the Rolling Stones sessions for Let It Bleed, Richards contributed his first solo lead vocal on You Got the Silver. In 1969 the Stones were in the middle of their golden era where they put out exceptional albums like Beggars Banquet, Let It Bleed, Sticky Fingers, and Exile on Main Street. They couldn’t be derailed. Can we say the same for the markets?

Market pundits calling for another top have pointed to August as a month that’s ushered in some idiosyncratic volatility over the past few decades. Here’s a brief retrospective of unusual events that precipitated significant moves in the VIX® Index during the month of August:

  • 1998: Long Term Capital Management implodes (VIX Index high 45.02)
  • 2002: Culmination of Enron, WorldCom, Adelphia, Martha Stewart, and Accounting (Arthur Anderson) scandals. (VIX Index high 43.06)
  • 2007: Quant Hedge Fund Implosions. (VIX Index high 31.76)
  • 2011: U.S. Debt Downgrade and Euro Sovereign Debt Crisis (VIX Index high 47.56)
  • 2015: Chinese Yuan Devaluation (VIX Index high 53.29)

More recently, the markets have grappled with some less significant (in hindsight) August events like the North Korean escalation during 2017, which was arguably one of the least volatile years on record. Last year there was sabre rattling during August about tariffs briefly spooking capital markets. You can find VIX Index data going back to 1990 here.

Over the last decade, on average, August has been the worst month of the year for the S&P 500 (followed by May). Since 2010, the average performance of the S&P 500 during the month of August has been a decline of 1.29%. The “lowlights” include:

  • 2010: S&P (4.74%)
  • 2011: S&P (5.68%)
  • 2015: S&P (6.26%)

While history can be a useful guide, the question becomes, what is moving the markets in August of 2020?

The most recent AAII Investor Sentiment data shows the lowest level of bullishness in quite some time. Just over 20% of respondents characterized their outlook as bullish, which is very much at the low end of the historical range.

Source: AAII Sentiment

There’s been an earnings deluge. Last week 130 of the S&P 500 constituents reported numbers for Q2, the period when the real effects of the economic shut down kicked in. There’s been increasing bifurcation with clear winners and losers in the Work-From-Home (if you work at all) economy.

S&P Dow Jones Indices tracks equity dispersion, volatility, and correlation levels and recently highlighted “an unusually wide range of surprises, both positive and negative, which kept equity dispersion high. In tandem, correlations declined rapidly, with average correlations between the daily returns of the S&P 500 constituents collapsing to the lowest reading this year, coming in at a well below-average 0.18 for July”.

Cboe calculates implied correlation indices as well. These indices compare the relative cost of SPX® Index options to comparable options on the 50 largest stocks in the S&P 500 Index. There’s a strong historical relationship between macro volatility and overall correlations. To learn more about the Implied Correlation Indexes, click here.

In general, when “volatility events” occur, correlations move toward 1.00 (a positive correlation). As volatility abates, correlations tend to weaken, which is what we’ve seen over the past few weeks and months. This trend warrants attention as earnings season winds down.

Here’s a five decade look at Continuing Claims for Unemployment Insurance from the St. Louis Fed.

Source: St. Louis Federal Reserve

Much has been made of the political wrangling around the possible extension of enhanced unemployment benefits that ended in July. An argument could be made that the $600 in additional weekly benefits largely went right back into the economy and helped stave off potentially vicious cutbacks in spending on the part of consumers. Historically that type of retrenchment leads to further job losses as businesses are forced to manage ongoing revenue losses. 

On August 6, macro volatility, as measured by the VIX Index fell to the lowest levels (22.65 close) since February 25 (22.18). Despite these “relatively” low levels of forward-looking volatility, a VIX Index measuring in the mid-20s isn’t often associated with complacency.

20-day trailing (historical) volatility on the S&P 500 declined to 12.29% last week. That’s the lowest realized vol for the SPX since January 31 (2020). The spread of roughly 10 vol points between the VIX Index (~23) and 20-day historical volatility (~13) is highly unusual. In fact, the average for 2020 has been (2.10) vol points. In other words, 20-day HV has been 2 points higher on average than the VIX Index (closing) this year.

Source: Cboe Global Markets & Bloomberg

Since July 24, there’s been an unusually positive spread between forward vol as measured by the VIX Index and 20-day HV. For the better part of the past two weeks, the VIX Index has been +10.9 vol points over realized vol (20-Day). This divergence is likely unsustainable for any meaningful length of time. Either S&P 500 realized vol will pick up, which is potentially what the VIX is pricing, or one could expect the VIX to move back toward a more “normal” level in the teens.

Bloomberg article by Yakob Peterseil alluded to both the potential appeal to a “short vol” strategy in the current environment as well as the considerable risks if the macro backdrop changes.

In a previous Inside Volatility we called attention to the ratio of Gold to Silver. In short, based on respective prices, how many ounces of Silver it takes to buy one (1) ounce of Gold. Typically, gold will outperform in “risk off” environments like 2002/2003, 2008, and early in 2020.

We also highlighted the strength in the US Dollar earlier in the year, which has weakened dramatically over the past few months. While gold prices have garnered considerable attention of late by making new all-time highs (over $2000), silver has meaningfully outperformed. The Gold/Silver ratio has fallen from ~124 in March to ~73 currently.

The powerful bull market in precious metals has run parallel to a collapse in US Real Rates. Following the last Federal Reserve Meeting, the Fed Fund Futures (FFF) shifted and are now pricing in negative (short-term) rates in mid-to-late 2021. The FFF don’t price in any tightening until “at least 2023”. 

Source: Financial Times & Bloomberg

The “dog days” of an unusual summer are upon us. Equity markets globally continue to advance, and volatility measures have contracted. Derivative products are being broadly embraced. The graphic below comes from Trade Alert data and calls attention to option volumes, which have been very strong despite the lowest average execution size in history in the month of July (6.8 contracts). This likely indicates that individual traders remain engaged. Also of interest, in July the total calls relative to puts (ratio) were the highest in a decade. 

Source: Cboe & Trade Alert

“We age not by holding on to youth, but by letting ourselves grow and embracing whatever youthful parts remain”

Keith Richards - Life

August 11th in History

  • 1860: First ever successful silver mill in the United States (Virginia City, NV). Samuel Clemens was a local writer for the Territorial Enterprise newspaper. By 1862 he became known as Mark Twain.
  • 1919: The Green Bay Packers football club is founded and named after their sponsor and Indian Packing Company.
  • 1929: Babe Ruth became the first baseball player ever to hit 500 home runs. Ruth finished his career with 714 home runs which was surpassed by Hank Aaron (755) and Barry Bonds (762).
  • 1934: Federal prisoners first arrive at Alcatraz in the San Francisco Bay.
  • 1992: USA Mall of America (2.5 million sq. ft of retail space and more than 500 shops opened (Bloomington MN.). The Mall of America is now operated by Triple Five Group who apparently didn’t make loan payments ($1.4 billion) in April and May. 


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