Inside Volatility Trading: The Tipping Point?

Kevin Davitt
November 3,2020

“Political conflicts are merely surface manifestations. If conflicts arise you may be sure that certain powers intend to keep this conflict under operation since they hope to profit from the situation. To concern yourself with surface political conflicts is to make the mistake of the bull in the ring, you are charging the cloth”

-William S. Burroughs

The Tipping Point?

Twenty years ago, Malcolm Gladwell went from a respected writer for The New Yorker to a sought after “public intellectual” following the publication of The Tipping Point: How Little Things Can Make a Big Difference. His books are typically an amalgam of psychology, economics, and a bit of sociology conveyed through anecdotal lenses.

In Tipping Point, Gladwell focuses on identifying the inflection points when ideas “catch fire.” The book was published a year before MySpace even existed. Social networking in 2000 was exemplified by AOL or Yahoo messenger. The topic was arguably well ahead of its time.

The first chapter of the book is titled “The Three Rules of Epidemics.” Gladwell points out how powerful so-called “super infectors” can be in the spread of disease or viruses. In the developed world, “viral spread” of a commercial idea (or product) like the iPod (introduced 2001) is the explicit goal of engineers and marketers.

These concepts have proliferated as politicians, academics, and businesses of all stripes have studied and implemented strategies based on a positive interpretation of the network, or viral, effect. They employ “influencers” on social platforms like Instagram, Twitter, or TikTok and Twitch to leverage their messaging. Gladwell highlights “super infectors,” connectors, and eventually salesmen and women as the influencers behind buying behaviors.

2020 continues to provide evidence of a negative and literal viral spread. Globally, more than 45 million people have been infected with SARS-CoV-2 (coronavirus). It’s now spreading more rapidly than at any point previous. Local health officials are now leveraging state resources to combat viral spread. States are leveraging national governments. Governments are leveraging international bodies. Successfully leveraging resources has been critical for commercial successes as well as the eradication of novel diseases.

Leverage

Derivative users understood the power of leverage well before Ulta Beauty partnered with Kylie Jenner. Futures and options have varying degrees of leverage inherent, which beget capital efficiencies in terms of hedging or outright exposure.

The leverage embedded in futures contracts is a function of the margin requirement. Here is a link to the most up-to-date margin requirements for CFE® products. VIX® futures (including Mini VIX contracts) have a tiered margin structure whereby longer dated contracts have lower requirements than futures closer to maturity. Margin requirements are also reduced when futures contracts are spread. For example, a long/short November VIX (standard) future would require (at least) $13,750 in initial margin for a speculative customer. If instead that customer spread Mo. 1 v. Mo. 2 futures (in this case a Nov/Dec spread), the initial margin requirement would be $6,017.

With options, the buyer has “control” or exposure to an asset of significant notional value with a smaller investment. Short-dated OTM calls and puts generally have the most leverage. The tradeoff is the significant time decay (theta) the buyer of those options may experience.

Term Structure

I am writing this the week prior to the general election. The newsletter is hitting your inboxes on November 3, a potential inflection point from a political standpoint. In terms of forward volatility, what a difference four years can make.

Source: LiveVol Pro

This LiveVol snapshot shows the VIX futures term structure on the Wednesday prior to the 2016 and 2020 general elections. The November futures closed at 35.60 on Wednesday, October 28, 2020 whereas a week before the 2016 election the front month contract settled at 18.30. The Nov futures are ~95% higher than they were at the same point four years ago.

In this election cycle, the curve is in classic backwardation ahead of the “known unknown.” By contrast, in 2016, the VIX futures were exhibiting the more typical contango structure (Dec 2016 futures were at a very slight discount to Nov 2016 futures).

In 2016, the U.S. economy was growing, albeit at a slower clip than previous years. Full year GDP growth was 1.6%, curtailed in part by the Federal Reserve signaling their intent to regular rate hikes. The unemployment rate was 4.7% and falling.

In 2020, the U.S. and global economies are reeling from the COVID-19 pandemic. The markets are now repricing the risk of more restrictive measures on businesses globally related to increasing infections. GDP estimates for full year 2020 are varied, but unequivocally negative. Most analysts are predicting an annualized slowdown in the neighborhood of 5%. For greater context, here’s a visual of the (U.S.) Annual GDP Growth rate dating back to 1948.

Source: BEA & Trading Economics

The unemployment rate is now 7.9% (September data), which is down from the 14.7% reading in April. In short, the economic backdrop to this election is very different than the previous cycle.

Despite the fairly opaque scrim, the S&P 500 has performed quite well until very recently. However, the disconnect between broad economic measures, specifically GDP, and the S&P 500 hasn’t been this pronounced in more than six decades. In fairness, GDP is a backwards looking measure and broad-based indices are believed to be discounting the future. Markets look forward.

Source: @Soberlook & The Daily Shot

In some ways, this is analogous to the divergences we’ve highlighted between short term historical volatility measures and forward-looking implied volatility levels in the S&P 500® during different points this year. Typically, the two measures are highly correlated, but, as shown below, are three periods over the past year where SPX® Implied Volatility (IV) and Historical Volatility (HV) measures bifurcated.

Source: LiveVol Pro

In late 2019, realized volatility measures for the S&P 500 declined to their lowest levels in years (slightly below 5% HV around Thanksgiving). Despite the lack of market volatility, index options were pricing in the potential for future volatility in part because of the continued uncertainty about a trade deal with China. The market continued to (mostly) move higher until February 19, 2020.

In August of this year, realized SPX volatility fell below 10% (8% on August 28), but index options expiring in 30 days were trading on a 17% IV. A similar dynamic occurred in late October. 20-day historical volatility in the S&P 500 declined to roughly 17%, but the late November expiring options were trading with in implied volatility that was double the recent realized levels (34%). The election absolutely plays a role, but the ATM SPX options expiring in March of 2021 (142 days) settled on a 28.5% IV.

Derivative markets are pricing in high levels of uncertainty well into the future. This week’s election may lift that fog to some degree, but that’s not a “given.” The market continues to grapple with the prospect (and timing) of an effective COVID-19 vaccine. What will be the longer-term repercussions on earnings? Employment? Real estate?

Point Reyes, California is the foggiest place in the United States. Visibility is typically reduced to a few feet. That portion of California peninsula also has microclimates, all of which seems reflective of the current environment.

Lack of meaningful visibility with a few bright spots.

Technically Speaking

The S&P 500 suffered a ~10% drawdown on a closing basis between September 2and September 23. As of October 28, the S&P 500 is 5% off the closing levels from the 23rd of October. In September, the SPX closed 6.2% below its 50-day SMA before recovering. In late October, the index is 4.6% below the 50-day SMA. The 100-day moving held during the September selloff, but has given way during the current pullback.

Source: LiveVol Pro

In recent weeks, there’s been a substantial increase in the number of distinct accounts transacting in the Mini VIX futures contracts (VXM). On Monday, October 26, there was the broadest participation in VXM to date; higher than September 4, which was during the first significant equity decline since the Mini VIX futures were launched in early August. This trend bodes well for volume and liquidity trends.

Shifting to VIX options, there’s been an interesting trend that reemerged lately. Historically, VIX call trading dominates. In other words, the VIX put/call ratio is generally well under 1.0:1.0. There have been short time frames where more puts than calls trade, but it’s the exception…until very recently.

Source: Charts

The average VIX put/call ratio in October (through 10/28) is 1.68:1.0. On October 16, the ratio was 3.48 VIX puts for every 1 VIX call. There have been only four sessions thus far in the month where more VIX calls have traded than puts.

The propensity for put trading in VIX can be attributed to the relatively high level of VIX futures across the term structure. The futures curve remains above 28 until July of next year. That’s atypical. There has also been a considerable amount of structured put spreads (1x2 ratios) that perhaps assume forward volatility levels will normalize in the coming months.

In a more typical environment, VIX structures are 1x2 call ratio spreads that generally provide for positive volatility exposure up to a certain point. It is important to note that 1x2 VIX call spreads (long one unit, short two) carry significant exposure in the event of a large move higher (and settle) on the associated futures contract.

As of October 26 (subject to regulatory review), Cboe transitioned the daily marking time and settlement price calculation for many proprietary products to 3:00 p.m. CT. This includes SPX/SPXW options, the Mini S&P 500 Index options (XSP), as well as VIX/VIXW options. For more details, see the press release here.

So, election day is finally upon us. It will be fascinating to see if a clear victor emerges in the next few days or if it drags into December (or beyond). What’s the makeup of the Legislative branch of government for the next two years? What will it mean for specific sectors and the market as a whole?

Historically, November and December have been strong months for the S&P 500 Index. This year, however, has been anything but normal. We wait, we watch, and we evaluate.

Danger I've been told to expect it

I begin my descent down the cold granite steps

And who could have turned among those I confide in?

I think that I know what I haven't known yet

Cause a week is a month and an hour a day

When your reaching just pushes it further away now

With your past and your future precisely divided

Am I at that moment? I haven't decided, I haven't decided

-Anastasio/Marshall

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