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Tale of Two Volatilities, Part 2

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February Volatility

If 2017 was “the best of times,” then Feb­ru­ary 2018 was “the worst of times”—at least in the volatil­i­ty mar­kets. Dur­ing the first week of Feb­ru­ary what was pre­vi­ous­ly all qui­et on the volatil­i­ty front quick­ly turned to “Vol­maged­don.”  Mar­ket par­tic­i­pants who had been lulled for so long with the low volatil­i­ty envi­ron­ment of 2017 were remind­ed how quick­ly things can change.  In “A Tale of Two Volatil­i­ties, Part 1,” we explored how option implied volatil­i­ty can actu­al­ly rise when the mar­ket is mov­ing quick­ly high­er and set­ting new highs.  This fol­low-up will eval­u­ate what occurred the first week of Feb­ru­ary 2018, how volatil­i­ty strate­gies fared, and the new volatil­i­ty regime we have now entered.

 

February Skew Overview

On Feb­ru­ary 5, 2018, on the heels of ris­ing rate expec­ta­tions, the S&P 500 dropped 4.1% record­ing its largest one-day move since 2011.  This end­ed 300 trad­ing days with­out a down­ward move of more than -2% in the index.  The VIX, in turn, record­ed its largest-ever per­cent­age increase (115%) clos­ing at 37.32 from the pre­vi­ous day’s close at 17.31.  Addi­tion­al­ly, stock cor­re­la­tions increased and reached their high­est lev­els since August 2015.

Let’s begin by exam­in­ing what hap­pened to the volatil­i­ty skew as the mar­ket sold off in ear­ly Feb­ru­ary.  Remem­ber from Part 1 that skew is the rel­a­tive dif­fer­ence in pric­ing between down­side strikes (mon­ey­ness less than 100%) and upside strikes (mon­ey­ness greater than 100%).  The gen­er­al theme in Jan­u­ary was that of a declin­ing skew as investors imple­ment­ed stock replace­ment strate­gies via upside calls and over­writ­ers were forced to cov­er their short call posi­tions due to the speed of the market’s ral­ly.  The demand for upside calls increased with a rapid­ly ris­ing mar­ket.

Things reversed dra­mat­i­cal­ly in Feb­ru­ary. The graph below com­pares the skew curve from Jan­u­ary 26 to the shape of the same skew curve from Feb­ru­ary 8, 2018.

1 Month Volatility Skew - Tale of Two Volatilites Part 2 - Swan Blog

Source: Bloomberg, Swan Glob­al Invest­ments

The graph above shows two things. First, there was an increase in over­all volatil­i­ty. This equates to ALL options increas­ing in val­ue as a func­tion of increased demand for option pre­mi­um across the spec­trum. Sec­ond­ly, there was a marked increase in skew.  In oth­er words, not only was there an increase in demand across the board for option pre­mi­um, but there was a rel­a­tive increase in demand for down­side puts as investors rushed to pur­chase pro­tec­tion as the mar­kets sold off.

To show­case this fur­ther, the 25-delta put-call skew we saw on Jan­u­ary 26 had trad­ed in the 22nd per­centile over the last 5 years. Mean­ing, over the last 5 years, 78% of all obser­va­tions had skew trad­ing high­er. On Feb­ru­ary 8, 2018, that per­centile had increased to the 100th per­centile.

 

The Worst of Times for Risk Control Strategies

So, what was the cause of the extreme move­ment in volatil­i­ty?  First, there was a delever­ag­ing from the risk control/risk par­i­ty com­mu­ni­ty. These strate­gies tar­get a spe­cif­ic volatil­i­ty or equi­ty ratio and must rebal­ance their port­fo­lios with mar­ket move­ments. For exam­ple, a short gam­ma strat­e­gy must buy volatil­i­ty as volatil­i­ty is increas­ing or sell equi­ties as equi­ties are decreas­ing. As we wit­nessed, these moves can hap­pen extreme­ly quick­ly and have cost­ly effects

On Feb­ru­ary 5, inverse short VIX prod­ucts were forced to rebal­ance their port­fo­lios near the mar­ket close and in the after-hours mar­ket. This can result in a cost­ly rebal­ance. For instance, sup­pose you have a $100 port­fo­lio and you want short VIX expo­sure with 1x lever­age.  This requires sell­ing $100 of VIX futures.  Now sup­pose the VIX increas­es and the expo­sure is now $150.  The short VIX port­fo­lio is now worth only $50 mak­ing you 3x lev­ered.  To de-lever, the port­fo­lio requires pur­chas­ing $100 of risk to main­tain the 1x expo­sure desired. The more the VIX increased, the more risk needs to be pur­chased to main­tain the desired expo­sure.

As the mar­kets sold-off in Feb­ru­ary with the steep rise in option volatil­i­ty, there was an excep­tion­al amount of VIX futures pur­chased, which poten­tial­ly con­tributed to the sell-off in S&P futures dur­ing that time. The lack of liq­uid­i­ty for VIX futures in the after-mar­ket ses­sion high­light­ed the “fragili­ty” of these types of strate­gies which suf­fered steep loss­es.  In and of itself, short­ing volatil­i­ty is not a “bad” thing and there are numer­ous stud­ies and strate­gies that employ risk pre­mi­um har­vest­ing to add incre­men­tal returns to port­fo­lios.  How­ev­er, short­ing volatil­i­ty while using exces­sive lever­age can quick­ly become chal­leng­ing to man­age under times of mar­ket duress.

 

A Regime Change?

And what about real­ized volatil­i­ty?  Well, real­ized volatil­i­ty spiked as well.  Risk pre­mia har­vest­ing strate­gies are based on the premise that over time implied volatil­i­ty trades high­er than what is actu­al­ly real­ized in the under­ly­ing mar­ket.  The ear­ly Feb­ru­ary move low­er, by one met­ric, was one of the largest 5-day per­cent increas­es in his­to­ry.  The only oth­er times that wit­nessed greater 5-day real­ized volatil­i­ty per­cent­age increas­es were May-1940, Ger­man blitz; May-1948, Israel inde­pen­dence declared; and Octo­ber-1987, Black Mon­day crash (Source: Bank of Amer­i­ca Mer­rill Lynch).

What does all this mean going for­ward? In pre­vi­ous writ­ings, we’ve made the case that volatil­i­ty tends to trade in “regimes”—i.e., low-vol, mid-vol, and high-vol envi­ron­ments. Undoubt­ed­ly, 2017 was a low-vol regime. How­ev­er, a tremen­dous amount of short-gam­ma is now out of the mar­ket.  The cat­a­lysts for anoth­er spike in the VIX of the likes just wit­nessed have been dimin­ished, at least in the near-term. Mar­ket sell-offs from this point should be more “order­ly” in keep­ing the VIX in its new volatil­i­ty regime.

As we can see from the graphs below, the start of 2018 for the VIX looks quite sim­i­lar to that of 2007 when the 2004–2006 low volatil­i­ty peri­od came to an end.

2007 vs 2018 VIX - Tale of Two Volatilites Part 2 - Swan Blog

Source: Bloomberg, Swan Glob­al Invest­ments

 

Throw in tax cuts, tar­iffs, and pos­si­ble trade wars, don’t expect the VIX to see sin­gle dig­its any­time soon.

 

About the Author: 

Chris Hausman, CMT®, Director of Risk Management and Chief Technical StrategistChris Haus­man, CMT®, Direc­tor of Risk Man­age­ment and Chief Tech­ni­cal Strate­gist, focus­es on risk assess­ment and man­age­ment for the Defined Risk Strat­e­gy invest­ments and posi­tions. He mon­i­tors risk across all of Swan’s port­fo­lios and pre­pares stress tests, risk assess­ment reports and con­tributes to strate­gic deci­sion mak­ing as part of the invest­ment man­age­ment team, as well as serv­ing as an addi­tion­al lay­er of over­sight for the trad­ing team. As a Char­tered Mar­ket Tech­ni­cian, he also acts as Chief Tech­ni­cal Strate­gist at Swan Glob­al Invest­ments.

 

 

 

Impor­tant Notes and Dis­clo­sures:

Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non-qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®).

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By | 2018-04-17T13:50:19+00:00 March 14th, 2018|Blog|Comments Off on Tale of Two Volatilities, Part 2: February