Cboe Global Markets

Inside Volatility Newsletter: The Certainty of Volatility

Kevin Davitt
▬
April 19, 2022

“‘Tis impossible to be sure of any thing but Death and Taxes”

-Christopher Bullock (1716)

Certainties

The “death and taxes” idiom traces its roots to the early 18th century play The Cobbler of Preston by Christopher Bullock. It has been referenced in many subsequent discourses by the likes of Daniel Defoe and Benjamin Franklin. Perhaps you’ve used the quip in recent weeks while preparing your annual statement of account for the government.

Certainty imbues this pithy statement. Death and taxes are certain.

I might add one other unavoidable certainty – volatility! Over the past couple of years, this piece has become a platform for analyzing and interpreting the inescapable idea of volatility.

Volatility just is.

Nothing remains constant, and in capital markets that change is synonymous with opportunity…and risk.

In my estimation, Chris Cole of Artemis Capital put it best:

“Volatility is no different in markets than it is in life. Volatility is an instrument of truth. Regardless of how it’s measured it reflects the difference between the world as we imagine it to be and the world that actually exists.”

So, what does the world look like now?

Here & Now

Living is more expensive these days. The Bureau of Labor Statistics’ (BLS) website has a CPI Inflation Calculator. As of February 2022, the calculator tells me I need $12,139.82 to buy what $10,000.00 purchased in January 2015. In other words, purchasing power has eroded by more than 20% over the past seven years.

CPI Inflation Calculator

Source: BLS

The CPI calculation has changed over time, but the BLS uses a weighted average of a basket of goods and services used by “households.” At present, the goods and services include things like food/beverages, housing, apparel, transportation, medical care, recreation, education, among others. The Core CPI data strips out the “volatile” food and energy costs.

Core CPI Data

Source: BLS & NY Times

The above chart plots the annual change in CPI (blue line) and the Core (grey line) dating back to 1965. The February data showed the largest annual inflation in 40 years. Inflation and market volatility are typically unsettling to consumers and long-term investors.

Concern about the recent ~15% decline in the S&P 500 Index and skyrocketing inflation is reflected in the University of Michigan’s Consumer Sentiment Index. Consumer spending accounts for about two-thirds of the U.S. economy. Government spending on things like defense, social security, and health care (Medicare, etc.) make up most of the other third.

There’s only been one other point in history where the UMich Sentiment was this low (59.4) and the economy was not in a recession: late 2011 at the height of European Sovereign debt crisis and following the only U.S. debt downgrade in history. Will the current backdrop with high inflation and tighter monetary conditions become the second exception? Let’s explore some other signals.

University of Michigan Consumer Sentiment Index

Source: University of Michigan, YCharts, Compound Advisors

Another harbinger of negative growth recently reared its unwelcome head. In early April the yield on 2-year U.S. treasuries exceeded the 10-year yield. That’s highly unusual. Let’s understand why.

The credit (bond) market is driven by risk – default – and duration (time). In general, if I choose to lend money for ten years, I expect a higher annual rate of return than if I lend funds for two years. Among other things, there’s more time for something to go awry. As such, the UST yield curve is typically in contango. That’s a familiar word for our readers, but to put it in this context (and for newer audiences), it means longer term interest rates are usually higher than short term rates. That premise underpins most of the financial system. Banks want to borrow at a low, short-term rate and lend longer term at a higher rate; the goal is to capture the spread or difference.

Similarly, the term structure for VIX futures is generally contango. Volatility futures that expire eight or more months in the future tend to trade at a premium to futures with a one-month maturity. Why? There’s more time for something to go wrong.

The chart below plots the yield for both the US 10Y (yellow) and US 2Y (purple) with the VIX Index (teal) overlay. The 10/2 spread was inverted between late 2006 and much of 2007. Another inversion occurred in the fall of 2019. Both situations preceded historic moves higher in the VIX Index. If you go back more than two decades, a 10/2 inversion occurred in late 1999 before the subsequent “dot com” bust.

VIX Index Inversion

Source: Bloomberg

But let’s not confuse correlation with causation. Interest rate spreads could not anticipate a global pandemic. This does not imply that a significant rise in the VIX index is bound to occur. However, the last few times the yield spread went negative was followed by periods of (much) higher than normal equity volatility.

So What?

Well, ‘praemonitus, praemunitus’ – more commonly – ‘forewarned, forearmed.’ This piece isn’t prescriptive, but rather serves as an attempt to call attention to interesting data and related concepts that increase investor IQ.

There are tools at our disposal that may mitigate future uncertainty, but as with any tool there are associated risks. What tools might you consider given the current backdrop?

Historically, potential inflation hedges (assets that may move higher when inflation increases/purchasing power declines) include commodities, real estate, and Treasury-Inflation Protected Securities (TIPS). Broadly speaking, commodities, and real estate are finite, meaning their availability is limited. However, those markets have already made significant moves to the upside.

By contrast, the VIX index have declined lately. The VIX Index is much closer to where it measured before inflation became a primary risk. The “normalization” of S&P 500 Index implied volatility levels stands out when compared to other forward-looking measures. 

The VIX Products

The tradeable suite of VIX products (futures and options) are also often considered hedges. The historically strong inverse relationship between the S&P 500 level and VIX Index (as well as related futures) drives their appeal. Put simply, when the S&P 500 Index declines, the VIX Index and tradeable futures tend to move higher. A hedge, in capital markets, should move in the opposite direction of the primary risk asset.

Over the year, but particularly in recent weeks, the VIX Index and related products have diverged from other volatility measures. This chart shows the percent change in various volatility measures relative to a year ago. The VIX Index is slightly lower whereas a bond volatility proxy (MOVE Index) is up 74%. Euro Stoxx 50 Index volatility is more than 50% higher than it was in late March 2021. Crude oil volatility is up 47% relative to this time last year.

The VIX Index March 2021 – March 2022

Source: Bloomberg

This reminds me of a saying my first risk manager would repeat: “something is only cheap (or expensive) relative to itself or something else.” Looking back a decade, the ratio between bond market volatility and the VIX Index is above the 90th percentile. The relationship between the VIX Index and crude oil volatility is also in the +90%. The divergence between Euro Stoxx Index and VIX Index volatility is even greater. (Source: Chris Murphy, SIG International)

As of late March, the VIX Index seems “cheap” relative to some other forward risk measures.

Uncle Sam

For U.S. residents, Monday April 18 is the deadline for filing your 2021 tax returns or an extension. The Internal Revenue Code is roughly 2,500 pages long. That’s about twice the length of Leo Tolstoy’s epic War and Peace. Translation, it’s dense.

Under section 1256 of the Tax Code, profit and loss on transactions in certain exchange-traded options and futures are entitled to be taxed at a rate equal to 60% long-term and 40% short-term capital gain or loss, provided that the market participants involved, and the strategy employed satisfy the criteria of the Tax Code. Market participants should consult with their tax advisors to determine how the profit and loss on any particular option or futures strategy will be taxed. Tax laws and regulations change from time to time and may be subject to varying interpretations.

Very few people are thrilled by the thought of filing taxes, but in this case, there can be a meaningful implication for certain products.

Gratitude

This is my final iteration of Inside Volatility. I’ve thoroughly enjoyed the opportunity to evaluate the markets with an emphasis on volatility during my time at Cboe. I’ve learned so much from colleagues past and present. There’s always something new to understand, and there is a piece of each of them in all my work.

Thomas Wolfe penned You Can’t Go Home Again in the late 1930s, but my experience argues otherwise. My professional life began in the fall of 1999 when I stepped on the Cboe trading floor, and a new world emerged for me. I was introduced to a new language, to new tools. The volatility embedded in calls and puts changed my life, as options reinforced the reality that change is constant. The velocity of change can be significant or minimal. Volatility just is.

In late 2015, I came home again – to Cboe, this time as a part of the Options Institute (OI). I watched the derivative markets flourish and contributed to the expansion of the OI. I experienced new life when my first and only child was born. I encountered death when my dad passed away from brain cancer. Change is constant.

To best manage change, I encourage you to keep learning and observing. The Options Institute is excited to continue to offer ways to help you do this as you explore and engage in the world of financial derivatives.

Thank you all for your readership and support.

“Volatility (can) hurt but is necessary for growth. In nature volatility is so fundamental that the trees of the great sequoia forest will not release their seeds without first sensing heat from wildfires. It is from the flames of change that we derive the potential for healthy resurrection and birth.”

-Chris Cole

All things must pass

None of life’s strings can last

So, I must be on my way and face another day

-George Harrison

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  • Although the VIX Index generally tends to be negatively correlated with the S&P 500 Index – such that one tends to move upward when the other moves downward and vice versa – that relationship is not always maintained.
  • The prices for the nearest expiration of a VIX Index Product generally tend to move in relationship with movements in the VIX Index. However, this relationship may be undercut, depending on, for example, the amount of time to expiration for the VIX Index Product and on supply and demand in the market for that product.
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