Volatility Markets’ Misadventures
Mark Twain, also known as Samuel Longhorne Clemens, has been dubbed “the founder of American literature” (William Faulkner). Twain was a well-known author and public thinker. As a result, he’s become one of history’s most (mis)quoted writers/speakers. In June 1897, he sent a missive that was commonly misunderstood in response to allegations that he had died: ” “I was even told I was dead by reliable sources. My condition was sparked by his [Twain’s cousin’s] illness. My death was exaggerated in the news.”
When I saw a tweet from Benn Eifert, I was reminded of Twain’s witty perspective. Market analysts have forecast the downfall of option-based volatility selling tactics for several years. To put it another way, tales of the “short-vol” trade’s demise have been highly overblown.
AUM of Public Funds (Mutual Funds, ETFs, and CEFs) in Option Selling Strategies (Exhibit 1A).
@bennpeifert, Dr. Benn “DJ D-Vol” Eifer, @bennpeifert, @bennpeifert, @bennpeifert, @bennpe
Short volatility traders have existed throughout history, and especially since the introduction of listed options in 1973. Short vol trades were traditionally structured with over-the-counter (OTC) products such as volatility or variance swaps. When Cboe(R) debuted VIX(R) futures and VIX(R) options in 2004/2006, it changed the volatility environment. Tradeable VIX products transferred a lot of the same risk from the opaque OTC market to the listed, transparent exchanges. The short vol trade is still alive and thriving, according to Benn’s graphic.
While there are many possible techniques, handling short volatility positions entails a high level of risk. Volatility indicators (both real and implied) can fluctuate dramatically and without warning. According to historical data, half of the VIX Index’s greatest close-to-close changes have happened since 2018. To put things in context, VIX data dates back to 1990.
The VIX’s Ten Biggest Close-to-Close Spikes
Macrooption.com is the source for this information.
Returning to the first graph, the blue line represents the assets under management (AUM) for option-selling mutual funds, ETFs, and Closed End Funds. The green line represents the total number of funds that use certain strategies.
There are a few things that jump out in particular. Following the 2008 Global Financial Crisis, the number of funds using short volatility positions began to rise. Following the European sovereign debt crisis in 2012, there was yet another shift in the market, with significantly more corporations pursuing short vol tactics.
In 2008, the average VIX Index level was 32.7. (the highest to-date). With an average VIX Index of 29.25, the year 2020 comes in third (after 2008 and 2009). It seems to reason, in my opinion, that short volatility tactics generally follow periods of high macro volatility.
In many ways, controlling short volatility risk is similar to the insurance business. Selling “insurance” during a time when premiums (the cost of protection) are historically low is opportunistic, in theory. It’s crucial to remember, however, that insurance companies don’t just store all of the risk connected with their underwritten policies. Insurance companies, like many other option traders, will hedge their bets in other markets (reinsurance, etc.).
When it comes to AUM growth, there is a definite shift in flows around 2013. I want to be clear about the difference between causation and correlation. Quantitative Easing (QE) initiatives could be argued to have been analgesics for macro turbulence.
Yardeni Research has compiled a detailed timeline of FOMC QE dates and decisions. Early in January 2013, QE3 was started. Despite the fact that the Fed “taped” that program in December of the same year, many investors had changed their minds. In many circles, a religious-like confidence in “the Fed put” (or implicit protection against huge asset value declines) developed.
Potential Reward vs. Risk
Low interest rates encourage people to shift away from high-risk investments. Many fixed income products’ yields become unattractive as a result of the introduction of a “zero interest rate” environment. The promise of producing profit through riskier option writing tactics became generally accepted. Volatility in the stock market has decreased.
The 12-month S&P 500 Index realized volatility never exceeded 17.5 percent between January 2013 and February 2020. For that time span, the average was 12.66 percent. The average for the entire year of 2017 was a pitiful 8.94 percent. Most short option premium tactics will be successful against this backdrop. Success breeds confidence, creating a “virtuous” loop.
Until the cycle is completed.
The huge increase in realized volatility in February 2018 and the continued volatility in 2020 (red circles in example 1A) resulted in losses in short vol strategies and AUM drawdowns. The number of funds actively selling volatility remained unchanged last year, although AUM has increased as volatility has decreased. The S&P 500 Index’s 12-month realized volatility has dropped to 15.9%, while 1-month measures are now around 7.2 percent.
The graph below shows the 1-month realized volatility of the S&P 500 Index over the last five years. The drawdowns in the S&P 500 Index are indicated by the callouts correlating to major spikes in realized vol.
1-Month Realized Volatility of the S&P 500 Index
S&P Global Here & Now is the source for this information.
“It’s hard to see by stars and shadows.” – Huckleberry Finn’s Adventures
We’re nearing the end of the second quarter. Some of your accounts are expected to get a quarterly statement soon. In a similar vein, many asset managers are judged on their quarterly performance in comparison to the market. The most actively traded U.S. commodities (including equity indices) performed in Q2 and year-to-date, as shown below (YTD).
Since late October 2020, right before the most recent U.S. elections, the S&P 500 Index hasn’t had a 5% peak-to-trough decline. The story is the same in terms of VIX across time horizons: the S&P 500 Index’s projected volatility is lower.
Performance of Commodities in Q2 2021 vs. YTD 2021
Finviz.com is the source for this information.
For a busy visual, here are some quick highlights:
This year and in the previous quarter, energy prices have risen.
Ethanol and gasoline futures have led the pack so far this year.
Ethanol and natural gas futures are the top performers on a quarterly basis.
In 2021, WTI crude oil has increased by 50%.
The price of gasoline futures has risen by over 56%.
Lumber futures are up 30% this year, despite the fact that July lumber is 50% below the early May contract’s (all-time) highs.
Bond futures have dropped in price (yields higher). In recent weeks, the financial press has been dominated by inflationary tales. In comparison to the end of last year or the middle of 2020, consumers are paying more for various goods and services. Over the last year, the Federal Reserve’s balance sheet has doubled. They had $4 trillion in assets in March of last year. As the economy normalizes, the pace of their asset purchases has slowed, and as of last week, their balance sheet held $8.06 trillion in securities.
Despite the fact that treasury yields have increased in 2021, they remain historically low. Bond yields for assets with varying risk profiles have fascinating correlations. One method market players might utilize to compare comparable rates is the option-adjusted spread (OAS). Given that many products include inherent optionality (callable) features, it’s probably superior than simply comparing yields to maturity. The OAS model “adjusts” to accommodate the “choice” that many people value.
High Yield Credit OAS and the VIX Index
Cboe Global Markets and the St. Louis Fed are the sources for this information.
“All generalizations, including this one, are incorrect” – Mark Twain
The OAS spread for high yield credit is seen above, with the VIX Index superimposed. The OAS spread data dates back to 1996, whereas the VIX data dates back to 1990. When high yield spreads widen, there is a proven butterfly impact in the VIX Index, in my opinion.
The OAS spread has been steadily decreasing (along with the VIX Index) and is now at its lowest point (3.15) since June 2007. The all-time lows were reached in May of 2007 (2.46) just as the subprime market began to reverberate.
The VIX and rate spreads may continue to narrow/decline. The Fed, according to Fed Chair Jerome Powell, is dedicated to strengthening labor markets in the short term, but there is growing anxiety among Fed voters about sustained inflationary pressures. The Fed Funds rate “dot plot” (forward-looking) projections now show the possibility of two rate hikes in 2023. The previous “consensus” was that no increase would be made until 2024.
“Facts are unyielding, but figures are more malleable,” said Mark Twain.
Rates are now low and are expected to remain so for the foreseeable future. Consumption and risk-taking are apparently encouraged by the “zero-interest rate” environment. Savers face a penalty. Given the current rate environment, leverage has grown more appealing. Real estate investing, carry-trades, and speculating (on margin) are becoming increasingly appealing due to the current zeitgeist. The interest rate risk is a common stumbling block for these undertakings, and it remains modest.
The question becomes (at some point)…at what cost?
Margin Debt as a Percentage of Nominal GDP
NYSE/FINRA/Hussman Advisors are the sources for this information.
The NYSE and FINRA have produced data on Margin Debt levels in relation to nominal GDP in the United States. The marked peaks (September ’87, March ’00, July ’07, and January ’18) are concerning in terms of future volatility. This statistic reminds me of Thomas Piketty’s Capital in the Twenty-First Century, in which the value of capital has grown faster than the economy as a whole. Piketty advocates for a global wealth tax, which appears improbable.
In a related vein, the notion of a Global Corporate Minimum Tax looks to be gaining traction following the latest G7 conference. In a nutshell, cortical shifts/n
