Send a Message

[contact-form-7 id="2362" title="Send a Message"]

Tale of Two Volatilities, Part 1

Down­load PDF

January 2018 Volatility

It may seem an eter­ni­ty ago, but at the end of 2017 every­one was won­der­ing why there was such a lack of volatil­i­ty in the mar­kets.  Well, 2018 showed us how quick­ly things can change.  Jan­u­ary 2018 was on pace to have one of its best months in near­ly 30 years.  The S&P 500 Total Return fin­ished pos­i­tive by 5.73% after giv­ing back some per­for­mance the last few days of the month.  The last time we saw this kind of ral­ly was back in Jan­u­ary 1989 when it gained 7.32%, the best month over the last 30 years.

While some investors were shocked by the spike in volatil­i­ty, care­ful analy­sis of the over­all volatil­i­ty curve and a char­ac­ter­is­tic called “skew” can pro­vide valu­able insight to mar­ket expec­ta­tions.  As the cur­rent bull mar­ket was rag­ing upwards in Jan­u­ary, an inter­est­ing devel­op­ment was occur­ring with respect to the shape of the volatil­i­ty curve: as the mar­ket went up, so did volatil­i­ty.  At the time of this writ­ing (2–12-18), volatil­i­ty has now tak­en on an entire­ly dif­fer­ent char­ac­ter­is­tic, but this will be explored in a sec­ond post. This post will focus on January’s volatil­i­ty curve.


Taking the Elevator Up

In a pre­vi­ous blog post, “Where Is the Volatil­i­ty?”, we broke down the con­struc­tion of the VIX index. In it, we dis­pelled the notion that the VIX is a “fear index.” At its core, the VIX does not mea­sure fear or volatil­i­ty, but instead the sup­ply and demand for short-term options. The sup­ply and demand of var­i­ous puts and calls are dynam­ic with their prices shift­ing accord­ing to mar­ket expec­ta­tions.

In nor­mal mar­ket con­di­tions, volatil­i­ty is expect­ed to decrease when the under­ly­ing mar­ket ral­lies and increase when the under­ly­ing mar­ket falls, affect­ing the demand for calls and puts. His­tor­i­cal­ly, down­side move­ments have been much greater and faster than move­ments to the upside, some would say the mar­kets take the stairs up but the ele­va­tor down. This rapid move to the down­side caus­es peo­ple to buy more pro­tec­tion. Thus, there is a greater ten­den­cy to pur­chase down­side pro­tec­tion when mar­kets move down than the ten­den­cy to pur­chase upside calls when the mar­ket moves up. This dif­fer­ence between the demand for puts and calls cre­ates what we call the volatil­i­ty skew.

In Jan­u­ary 2018, how­ev­er, rather than tak­ing the stairs up, the mar­ket took the ele­va­tor up.  The upward move in the S&P 500 increased real­ized volatil­i­ty and, as a result, also increased implied volatil­i­ty, albeit at a slow­er pace than what a typ­i­cal 6% trad­ing range should jus­ti­fy. With the mar­ket at or near all-time highs, one would expect for volatil­i­ty to be low, but the volatil­i­ty curve was repric­ing itself and increased, instead of decreased, volatil­i­ty, cre­at­ing an inter­est­ing volatil­i­ty skew.


Volatility Skew Explained

The volatil­i­ty skew can pro­vide some valu­able infor­ma­tion for those trad­ing options. But what exact­ly is it?

Volatil­i­ty skew is the graph­ic rep­re­sen­ta­tion of the implied volatil­i­ties of indi­vid­ual options at giv­en strike prices with­in a par­tic­u­lar expi­ra­tion win­dow. Once we have the data, we plot the volatil­i­ty skew in a grid such as the one below with the implied volatil­i­ties along the y-axis and the strike prices on the x-axis. Each strike will have its own volatil­i­ty mea­sure­ment that is expressed as a per­cent­age.

SPX March 2018 Expiration Skew - Tale of Two Volatilities, Part 1

Source: Bloomberg, Swan Glob­al Invest­ments

The graph above illus­trates how in typ­i­cal mar­kets puts are val­ued more high­ly than call options.  Investors fear down­side moves in the mar­ket more than they antic­i­pate upside gains, so the rel­a­tive influ­ence puts have on volatil­i­ty mea­sures is out­sized. This kind of skew is also referred to as a “smile.”


Skew & Pricing of Options

Option prices are based on prob­a­bil­i­ties, and the volatil­i­ty used for each strike basi­cal­ly assigns more or less val­ue to a spe­cif­ic option.  Remem­ber the sum of all pos­si­bil­i­ties for an event to occur must be equal to 100%.  If I have an apple pie and cut it into sev­er­al slices, it does not mat­ter how many slices I have, it will still be one pie. Option pric­ing is based on the same premise. The implied curve above has not only cut the pie into “slices,” but assigns more to some sec­tions (strikes) and gives less to oth­er sec­tions (strikes).

Traders use pro­pri­etary mod­els based on math­e­mat­i­cal for­mu­las to “smooth” out any pos­si­ble kinks cre­at­ed by intra-day sup­ply by allo­cat­ing the appro­pri­ate amount of the “volatil­i­ty pie” to each strike based on sup­ply and demand.


Bargain or Expensive?

How steep or flat a skew is shows how cheap or expen­sive the options are on a rel­a­tive basis as down­side strikes (mon­ey­ness less than 100%) com­pare to upside strikes (mon­ey­ness greater than 100%). There are sev­er­al ways to cal­cu­late the steep­ness of the skew.

One way is to take the dif­fer­ence in volatil­i­ty between the 25-delta put and the 25-delta call, which is known as delta skew.  Anoth­er way can be just by tak­ing the dif­fer­ence between a strike based on mon­ey­ness, for exam­ple tak­ing the 90% strike volatil­i­ty ver­sus the 110% strike volatil­i­ty.  One can also cal­cu­late the skew by sim­ply tak­ing the dif­fer­ence on an absolute, rel­a­tive, or ratio basis.

By com­par­ing skew graphs from dif­fer­ent time peri­ods, we can see how mar­ket expec­ta­tions change over time have a snap­shot of where the rela­tion­ship cur­rent­ly stands. An anal­o­gy can be made to the yield curve. Investors gain insight into the fixed income mar­ket by ana­lyz­ing both the steep­ness of the curve and how the curve shifts over time. Options investors can gain insight into volatil­i­ty con­di­tions by look­ing at the steep­ness, or skew, of the curve as well as how it changes over time.

There are oth­er avail­able met­rics that can help mea­sure skew or tail risk such as the Cboe’s SKEW Index ( or the SMILE Index (


The January Tale

The graph below shows the volatil­i­ty skew for the SPX for a 1-month matu­ri­ty.  From 12–26-17 to 1–26-18 one can clear­ly see how down­side strikes (out of the mon­ey) puts declined in val­ue vis-a-vis upside calls (out of the mon­ey calls). Although sub­tle, the curve on 1/26 is a bit flat­ter than it was on 12/26.  Option traders call this a decrease in skew. This does not nec­es­sar­i­ly trans­late into a lack of down­side hedg­ing, but rather a greater demand for upside strikes. The mar­ket moved up so fast and so far in Jan­u­ary, upside strikes became more impor­tant in volatil­i­ty cal­cu­la­tions.

January 2017, 2018 1-Month Volatility Skew - Tale of Two Volatilities, Part 1

Source: Bloomberg, Swan Glob­al Invest­ments


One of the rea­sons for an increase in volatil­i­ty and decrease in skew in Jan­u­ary is attrib­ut­able to many mar­ket par­tic­i­pants being short upside calls (over­writ­ers) and being forced to cov­er as the mar­ket con­tin­ued to increase. In addi­tion, with option volatil­i­ty still at his­toric lows, stock replace­ment strate­gies via pur­chas­ing out­right calls or call spreads were being imple­ment­ed as opposed to pur­chas­ing out­right stock. The phe­nom­e­non of a ris­ing mar­ket and a ris­ing volatil­i­ty can­not last for­ev­er; it’s a sim­ple repric­ing of the risk pre­mia for an increase in real­ized volatil­i­ty.



In sum­ma­ry, volatil­i­ty does not always go down dur­ing mar­ket ral­lies.  The key thing is whether we are in new ter­ri­to­ry that war­rants a re-pric­ing of the volatil­i­ty curve.  We’ve made the argu­ment pre­vi­ous­ly that volatil­i­ty tends to trade in “regimes” of low-vol, mid-vol, and high vol.  Cer­tain­ly, 2017 was a low volatil­i­ty regime.  Do the speed, dura­tion, and mag­ni­tude of the market’s move­ment in Jan­u­ary and Feb­ru­ary her­ald a regime change?  Are the hal­cy­on days of easy mon­ey over?  Only time will tell, but if real­ized volatil­i­ty moves high­er, expect an increase in implied volatil­i­ty which can direct­ly lead to trad­ing oppor­tu­ni­ties.


About the Author:

Chris Hausman, CMT®, Director of Risk Management and Chief Technical Strategist

Chris 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®).

All Swan prod­ucts uti­lize the Defined Risk Strat­e­gy (“DRS”), but may vary by asset class, reg­u­la­to­ry offer­ing type, etc. Accord­ing­ly, all Swan DRS prod­uct offer­ings will have dif­fer­ent per­for­mance results due to offer­ing dif­fer­ences and com­par­ing results among the Swan prod­ucts and com­pos­ites may be of lim­it­ed use. All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. All invest­ment strate­gies have the poten­tial for prof­it or loss. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970–382-8901 or  097–021518



By |2018-10-02T10:59:43+00:00February 15th, 2018|Blog|Comments Off on Tale of Two Volatilities, Part 1