Cboe Global Markets

Inside Volatility Trading: Market Wisdom

Kevin Davitt
January 26, 2021

Woven in the fairy tales we fabricate each day

Are little golden strands of truth that glimmer in the light

-Anastasio/Marshall – Mountains in the Mist

Words of Wisdom

There are countless Wall Street truisms that are passed on from traders to trainees, portfolio managers to clients, and eventually into the mainstream. Chances are you’re familiar with most of these pithy bits of market wisdom.

“No one rings a bell when the market peaks.” – Unknown

“October: This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February.” – Mark Twain

“Be fearful when others are greedy. Be greedy when others are fearful.” – Warren Buffett

“Don’t confuse a bull market for brains.” – Humphrey Neill

When I was still new to the derivatives business, I remember a risk manager asking, “Do you want to be right, or do you want to make money?” In my mind, I wanted both. His point, which became clear in time (as a result of managing losses and personal reflection) was obvious:

our ego can be our own worst enemy.

Attribution Bias

Attribution bias is an unconscious mental tendency to credit positive outcomes to personal skills and poor outcomes to random luck. Others refer to the tendency as “Egonomics”.

That term was originally coined by Thomas Schelling. He was a brilliant polymath and Master of Game Theory. Schelling advocated for “pre-commitments,” whereby individuals set out to make decisions earlier than usual with an emphasis on “focal points.”

Focal points, in this context, are the pre-determined paths people choose absent other knowledge/communication. Schelling’s example involved attempts to meet a stranger in New York city without the ability to communicate when or where. Focal points are “natural” solutions to problems without the ability to coordinate. Grand Central Station at noon anyone?

This type of disciplined decision-making could help limit our opportunities for attribution bias. By thinking and behaving more “algorithmically” (if X/then Y) there’s the potential to manage uncertainty, or risk.

Many successful traders make it a habit to “pre-commit” to levels of entry and exit. Tools like limit and stop orders are one way to actively employ the concepts that game theory types advocate. Options can also be used to define outcomes over a specific time frame.

Schelling’s work was groundbreaking. Some contend that he kept Cold War tensions between the United States and the USSR from boiling over into nuclear war. Clearly there were lessons to be learned and behavioral finance types have expounded on Schelling’s theses. Could the concepts that gave rise to the longest period of peacetime in US history benefit individuals on a more personal level?

Humphrey Neill famously chastised investors not to ascribe their performance in bull markets to superior intellect. Neill wrote a book titled The Art of Contrary Thinking in the early 1960s, which was rooted in the belief that attribution bias exists and can be a significant detriment to longer-term success in capital markets.

One of the most intriguing portions of his work has to do with “The Problem of Knowing and Measuring Opinions.” Neill writes:

“In sum, if you employ the method of scanning opinions you have to continually ask yourself: Is this truly a generalized viewpoint, or is it perhaps a composite of my own views which the ‘mirror’ misleads me to think are those of the ‘crowd’?”

Markets cycle and the series of returns matters. Last year was the shortest bear market in history. Going back to the mid-1950s, the average recovery period for the S&P 500 Index works out to just less than two years. In the 1970s, it took nearly six years for the broad market to regain previous highs. I assume that Schelling and Neill would find utility in the VIX® Index and futures curve. They provide a dynamic look at prevailing sentiment. It’s “the crowd” quantifying uncertainty at various points in time.

S&P 500 Index Bear Markets and Recoveries

Source: LPL Research/FactSet

Here & Now versus Then & There

The S&P 500® continues to reach new all-time highs with relatively low levels of realized volatility. Excepting a one week stretch at the end of August (2020), 30-day SPX® historical volatility is at the lowest level since late January of last year (10.15%).

  • The large-cap Index has advanced 16% year-over-year.
  • The SPX is 72% higher than the March 23, 2020 closing lows.
  • The small-cap Russell 2000® (RUT®) Index has gained 115% since the March lows.

Despite that macro backdrop, near-term implied volatility in index options (SPX & RUT) are persistently high. The runoff elections in Georgia and Inauguration are now in the rearview. COVID vaccination efforts are ongoing. Nevertheless, the VIX Index measures around 22 and the RVX is near 30. Both forward volatility measures are at ~10-point premiums to 1-month realized levels.

In a more ‘normal’ market, following a months-long rally and relatively low levels of historic volatility, one might expect a VIX Index in the low teens. For the sake of comparison, between early 2017 and early 2018, SPX climbed about 25% Y/Y with a significant portion of those gains coming toward the tail end of the rally. The market continued to make new highs.

In late January 2018, 30-day SPX realized volatility was around 8.1%. The VIX Index measured between 11.5 and 13.0. That rally unwound famously over the course of two weeks with a 10% S&P 500 drawdown and a short-lived VIX Index spike into the 40s.

We’re two years and one ongoing pandemic removed from that correction.

Steep Volatility Skew

The current ATM 1-month implied volatility is trading around 17%. The 10% OTM calls and puts with 30 days until expiration are trading on a 14.8% and 28% volatility respectively. That’s indicative of meaningful skew. Below is a comparison of the SPX volatility skew for the Feb. cycle (30 DTE) and the Jan. 2022 skew (one year until expiration).

SPX Standard Vol Skews

Source: LiveVolPro

Despite the seemingly relentless climb, a wall of worry remains in place. According to a recent Deutsche Bank survey, the top three financial market concerns for investors are virus related. They include: a COVID mutation that vaccines might not address; serious vaccine side effects; and insufficient willingness to take the vaccine.

Survey: Which Factors are the Biggest Risk to Global Financial Markets in 2021?

Source: dbDIG Survey, Deutsche Bank Research

Markets are ultimately a reflection of the prevailing supply/demand dynamic. The willingness on the part of dealers and other liquidity providers to sell left tail risk has diminished since the early 2018 selloff. The vicious COVID selloff from last year only exacerbated the reluctance.

What happens to the index volatility surface in the event the S&P 500 consolidates recent gains or continues to grind higher? Do you believe the Federal/State/Local vaccination efforts can “thread the needle” and stop the spread? Will the job market continue to improve and bolster consumer confidence and spending?

Earnings Season

Late January always means that earnings season is in full swing. Valuation is normally a key metric for investors but the correlation between S&P 500 earnings and price has decoupled in the wake of the pandemic. The visual below comes from MacroTrends and illustrates the relationship between the S&P 500 Index level (blue) and EPS (orange). The grey areas indicate recessions.

The Relationship Between the S&P 500 Index and Earnings per Share (EPS)

Source: MacroTrends

S&P 500 earnings expectations were hammered last year. In fairness, earnings, unlike the S&P 500 Index, are backwards looking. While forecasts are starting to improve, many areas of the economy (travel/leisure, arts, energy, commercial real estate) will take years to return to previous profitability if they survive.

Better Explained: What is (Left) Tail Risk?

In statistical models, the “tails” are the ends of the distribution curves. Most of us are familiar with bell curves which illustrate outcomes, or the probability of future outcomes based on assumptions in your model. Distribution curves help us visualize the potential for given outcomes. The most likely events occur near the mean, or middle of the curve. The tails represent the least likely, or extreme, outcomes.

Tail Risk

Source: Cboe Options Institute

The “left tail” for the S&P 500 distribution curve represents outcomes (prices) well below the current mean. While these outcomes each have a very low probability of happening, remember low is not zero. They can, and do, occur. The 2020 period from February 19 to March 23 is now “Exhibit A” for left tail risk.

The visual below is slightly dated (does not include last year), but illustrative of the concept. On average, the S&P 500 has daily returns of +/-0.73%. In 2020, there were two sessions of +9.3% (9th and 10th largest up days ever). March 16, 2020, was the third-largest decline for the index ever when it fell 11.98%. Days earlier on March 12, the broad market fell 9.51% which was the sixth steepest daily move in history. 

In short, returns over long time frames will cluster around a mean, but they are not normally distributed. Volatility is also non-directional, but most investors are exposed on the left tail (S&P 500 prices lower) as opposed to the right.

Visualizing Every Day of the U.S. Stock Market for the Last 10 Years

Source: www.chartr.co

The demand for left tail risk mitigation in the form of OTM SPX puts remains substantial. As mentioned above, the 90%/110% SPX risk reversals (short put/long call) continue to trade “rich” relative to a more normal volatility environment. Liquidity providers need to manage their own exposure and look to be fairly compensated for assuming the short tail risk that hedgers demand.

Odds & Ends

Shipping rates, which are volatile, are back at the high end of their five-year range. Here’s a visual of the Baltic Exchange Dry Index:

Baltic Dry Index

Source: Trading Economics

The cost of moving goods gets passed on at some point. Perhaps the increase is “transient,” but if it is not, what does that mean for inflation figures later this year?

Shipping freight isn’t the only thing that’s relatively expensive these days. Median sales prices for US homes are just off all-time highs going into the Spring selling season. Commodity prices (ex-energy) are at five-year highs. Perhaps most concerning for investors, the CAPE ratio is a cyclically adjusted price to earnings measurement for the S&P 500. The highest ever level for the index was 44.19 in December of 1999. It’s currently right at 35.

Cyclically Adjusted PE (CAPE) Ratio

Source: Multpl

Finally, in fixed income, when prices are high, yields are low. Corporate High Yield rates can be viewed as a proxy for overall risk appetite. These debt instruments play a huge role in leveraged financial markets. Junk yields are making new lows after decade-high yields less than a year ago. What a turnaround.

Bloomberg-Barclays U.S. Corporate High Yield - Yield to Worst

Source: Bloomberg

The groove is out of fashion; These beats are 20 years old

I saw you lend a hand to the ones out standing in the cold

-David Byrne Strange Overtones

“Control is really chaos going your way for a while”

– Lego Heroes Episode


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