Cboe Global Markets

Inside Volatility Trading: Nothing Remains Unchanged

Kevin Davitt
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July 27, 2021

In my experience, travel (music, literature, etc.) is all about perspective. I am a “flatlander” who just visited Montana/Wyoming with my family and life-long friends. Departing Chicago and finding yourself in the northern Rockies inherently forces a perspective shift. We spent time in Yellowstone National Park and discussed John Muir, Lewis and Clark, and other early Western explorers. It's awe inspiring to observe how quickly the natural landscape moves from rolling plains to 14,000-foot peaks in the Grand Tetons.

Reflexively, I come back to the broad concept of volatility. Volatility is embedded in the natural order. Nothing remains unchanged. Everything is in a constant state of flux. Relative peaks and valleys. For every buyer there is a seller. There are bull and bear markets, up and down days, weeks, or months. There is chaos that gives rise to opportunity. Knowns and unknowns.

Here’s a look at the monthly average (closing levels) for the Cboe Volatility Index® (VIX® Index) going back to January 2020. Clearly, average monthly volatility levels as measured by the VIX Index have been normalizing alongside the global economy. The July average calculation is subject to change, but if it holds (or moves lower) it will be the lowest average monthly VIX measurement since January of last year.

VIX Index Monthly Average

Source: Cboe Global Markets/Options Institute

Randomness is when a human being can no longer compute all the factors. – Firas Zahabi

Humans strive for understanding. We crave certainty, but the “natural order” breeds uncertainty. Humans developed tools to help mitigate relative levels of uncertainty (think: agricultural, industrial, and ongoing technical revolutions/tools). Derivatives, which date back millennia, have always been tools for risk management. Options can be used to define the potential range of outcomes for a specific time frame. They help facilitate the inherent desire for determinism.

Spreading Risk

That brings us to an age-old trading adage: If you buy something, sell something.

Spreads typically reduce exposure to risk or uncertainty. Vertical spreads – where one buys and sells calls (or puts) in equal numbers with the same underlying and expiry – scale down:

  • Dollar risk (premium)
  • Directional risk (delta)
  • Time decay (theta)
  • Volatility - IV - (vega)

Those benefits come at the expense of capping potential profits in the event the underlying asset makes a sizeable move in the desired direction. Vertical spreads have predetermined risk/reward parameters. Perhaps it’s no wonder so many market participants gravitate to spread trading.

New to spreads? Check out this week’s edition of Simply Put for more.

I am not aware of a traditional market where spreading is a viable alternative. Modern markets are “one way” in the sense that you can buy or not buy goods. The funds flow from the consumers to the vendors; rarely is it the other way around. In fairness, roughly 8% of goods are returned after purchase (this percent is slightly higher on Amazon). By contrast, the derivatives marketplace has bi-directional flow. In other words, you can buy or sell products.

Spreading risk by buying and selling options or futures is a common derivatives strategy. In the volatility marketplace, spreads are typical for several reasons. The primary motivator for spread trading in VIX options and futures is (arguably) the fact that volatility measures are ultimately rangebound.

Volatility measures are “mean reverting.” In effect, volatility data tends to revert to longer-term averages over time. Some other data sets also exhibit mean reverting properties. For example, economic growth measures (GDP), price-to-earnings ratios (PE), and exchange rates. Technical trading approaches can be predicated on the propensity to regress to a mean. The choice and flexibility embedded in derivatives markets, and specifically in spreads, is a powerful feature. 

VIX (Futures) Ranges

Many futures and options traders look to express their outlook for expected volatility using spreads. VIX futures spreads can trade for debits or credits depending on the term structure. In other words, it’s possible to buy calendar spreads in VIX futures for a credit when the term structure is inverted. That doesn’t happen with equity option spreads. Calendar spreads (assuming horizontal) trade for debits.

VIX futures spreads depend on the relationship between the prices of contracts with different expiries. Generally, when expected volatility measures increase, the shorter-dated futures contracts move higher with a greater velocity than longer-dated contracts. In other words, they have a higher beta in relation to the VIX Index.

Beta of VIX Futures to the VIX Index

Source: Volatility Trading (cboe.com)

VIX futures cannot measure zero; there is an undetermined lower bound. The lowest-ever VIX Index close was 9.14 (8.84 intraday). The lowest ever VIX Index and futures levels occurred in 2017. On November 3, 2017 the VIX Index closed at 9.14 (all-time lows) and the November future settled at 11.17.

By contrast, the VIX Index established new all-time highs on March 16, 2020 (82.69). The March VIX futures contract traded as high as 76.25 and closed at 72.05, on that date.

VIX Futures Curve: March 16, 2020 vs. November 3, 2017

Source: Cboe LiveVol Pro

This does not imply that VIX futures couldn’t trade below 10.85 or above 76.25. That’s possible. While it’s unlikely that the VIX futures would trade more than 100, that too, is theoretically possible. Recall that the VIX Index is an annualized standard deviation calculation based on 1-month SPX options. An index cannot decline by more than 100%, but it could move up by 100%+. There is no cap for index volatility and during liquidation events (COVID/Financial Crisis/etc.) unusual things occur. 

Let’s walk through a hypothetical spread example using VIX futures prices as of July 15.

Imagine you forecast expected volatility to increase over the next few trading sessions. You prefer not to trade outright futures because the margin requirements are typically higher.

Forecast: Spread between July and August futures NARROWS (or inverts) because expected volatility measures increase. This relates back to beta of VIX futures. Historically, shorter-dated futures tracked the VIX Index more closely than those with longer maturities.

When equity volatility measures move up with velocity, the front month (or shorter weekly) contract tends to move more than other futures contracts. That also works in reverse. If the VIX Index trends lower, the short-dated futures typically lose value more quickly than other (VIX futures) contracts. 

VIX Futures Curve on July 15, 2021

Source: Cboe Live Vol Pro

Here is a hypothetical spread trade:

  • Buy 1 July VIX Futures: 17.60
  • Sell 1 August VIX Futures: 19.90
  • VIX Index reference: 17.00
  • Term Structure: Contango
  • SPX Reference: 4360
  • “Short 1 July/Aug. VIX Futures spread for 2.30 credit” ($2300 in standard contract/$230 in VXM).
  • Risk: Undetermined; if volatility measures remain grounded or move lower, the spread will likely widen.

Scenario 1: The Delta Variant of SARS-CoV-2 spreads in the U.S. and elsewhere, raising concerns about potential shutdowns. S&P 500® Index declines 2.80% from Thursday’s close by Monday afternoon. The VIX Index and futures move higher. [Note: this is actually what transpired between the July 15th close and midday July 19th.]

July 19, 2021: Delta Variant Concerns Result in a Decline in the S&P 500 Index and an Increase in the VIX Index

Source: Cboe Live Vol Pro

After Scenario 1 transpires:

  • July VIX Futures: 24.10
  • August VIX Futures: 23.80
  • VIX Index: 24.50
  • Term Structure: Backwardated
  • SPX Reference: 4240
  • The July/Aug spread is now positive (inverted) and you sell out of the position for 0.30 credit.
  • Result = Profit of $2,600 not accounting for frictional costs in a standard VIX future spread (+$260 in a VXM spread)

In that instance, the spread was assumed for a credit and since the term structure subsequently inverted, you were also able to exit the trade for a credit.

Alternative Scenario: Infrastructure plans move ahead. Delta Variant becomes of lesser concern. Earnings are consistently positive. No hawkish Fed rhetoric. The S&P 500 grinds 1.2% higher ahead of July VIX expiration. The VIX Index and futures continue lower.

Here are hypothetical figures after the Alternative Scenario transpires:

  • July VIX Futures: 16.75
  • August VIX Futures: 19.70
  • VIX Index: 16.20
  • Term Structure: Contango
  • The Aug/Sept spread is now 2.95 wide. You choose to exit and realize a 0.65 loss or $650 not accounting for frictional costs. (Loss in a hypothetical VXM spread would be $65).

Similar forecasts could be crafted using VIX options. It’s important to understand that VIX options prices are based on their related futures contracts and have unique sensitivities when compared to futures. VIX options have implied volatility assumptions embedded. There are time and delta considerations. While you can model their potential changes, hypothetical scenarios become trickier. 

What the VIX Index Tells Us About the S&P 500?

Here & Now

Do you feel euphoric? According to some sentiment measures, the S&P 500 is approaching uncharted territory. Callum Thomas runs Topdown Charts and the visual below includes a log scale of the S&P 500 (black line) and a model that includes the VIX Index (gray line), AAII’s Bull/Bear Sentiment readings (navy line), and the forward PE (1 year) for the S&P 500 (red line, lower chart). This blended metric is at levels last observed in early 2018 and during the tail end of the dot-com boom. The central driver of this leg higher has been forward P/E levels for the broad market.

Perhaps earnings continue to impress, and valuation measures subside. Q1 S&P 500 earnings made new highs for the first time since 2018 ($47.61 operating EPS). Markets are forward-looking vehicles. Picking tops (or bottoms) in a market is generally a fool’s errand. However, the use of derivatives to proactively protect against potential uncertainty is one way to possibly avoid making emotional decisions if/when the broad market experiences another sharp correction.   

The Euphoriameter: Combination of Forward P/E, VIX Index, and Bullish Sentiment

Source: Topdown Charts, Refinitiv Datastream

If there is one common theme to the vast range of the world’s financial crises, it is that excessive debt accumulation, whether by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom. — Carmen Reinhart

Small Caps Underperforming

Between the U.S. elections in early November 2020 and mid-March 2021, the small-cap Russell 2000 Index (RUT) boomed. Over the past month, the RUT has faltered as the tech heavy NDX and S&P 500 Index continued higher. The catalyst was an expectation that domestic small-cap companies would disproportionately benefit from the “reopening” and stimulus funds. Has the Russell 2000 priced in greater concern about the Delta Variant when compared to the bigger, more global Indexes?

Small-cap vs. Large-Cap Indices

Source: Cboe LiveVol Pro

Similarly, the point spread between the RVX Index (Russell 2000 VIX) and the VIX Index has widened in recent weeks. That spread had been narrowing between mid-March and late June. The small and large cap indexes have unique characteristics, including implied volatility tendencies. It will be interesting to see how much volatility premium (in point terms) the 30-day Russell 2000 Index options (RUT) price relative to the SPX in the coming weeks. 

Widening Point Spread Between RVX Index and VIX Index

Source: Cboe Global Markets/Options Institute

If we look further out in time, 1-year SPX options continue to price more uncertainty than they did prior to the acute selloff in March 2020. SPX options with a year until expiration are pricing on an implied volatility around 24.7%. That’s higher than any reading between late June 2016 and March 2020. In other words, the volatility surface for SPX options remains steep from a historical perspective. Cboe Global Markets tracks the 9-day VIX (~15.5), the VIX Index (~17.5.), 3M VIX (~21.45), 6M VIX (~23.5), and 1Y VIX (~24.7). All data is as of 7/16/2021.

Cboe S&P 500 1-Year Volatility Index, as of July 14, 2021

Source: S&P Global Research

It’s Always Different

Travel impresses upon the psyche just how much things can change from state to state, country to country, and from mile to mile. The natural landscape is always undulating, sometimes dramatically. In similar fashion, markets can stay within relatively contained parameters, gradually moving higher. Then, seemingly out of nowhere… a crater. 

Imagine stumbling into what would become Yellowstone National Park centuries ago. Had you moved from east to west, there would be monumental changes in elevation. Peaks and valleys. 

Highest Point in U.S. States (above sea level):

  • Illinois: 1,235
  • Missouri: 1,772
  • Kansas: 4,041
  • Nebraska: 5,427
  • Idaho: 12,668
  • Montana: 12,807
  • Wyoming: 13,809

The prevailing market landscape can also change quickly. There is no indication when you reach a market peak or valley. That too can be awe inspiring or risky if you haven’t planned for potential transformations. Volatility measures the speed of underlying moves over a given time frame. Options dynamically quantify forward looking risk measures. There’s no map that lays out what’s ahead, but there are tools to help manage the uncertainty. Do you know how to use them?

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