When the CBOE Volatility Index (VIX) briefly hit 50 for a few minutes earlier this month, it generated headlines around the world. There were few such headlines the last time the VIX spent an extended time above 50. The press had enough on its hands covering the collapse of the world financial system and the fact that 50% was being wiped off the value of stock markets.
In other words, the recent VIX spike was a great example of a financial market losing touch with underlying fundamentals, due to a technical event.
Vol vs. Vol-of-Vol
To understand that event, it helps to understand what the VIX is. The VIX measures the 30-day prospective volatility of the S&P 500 Index, determined by looking at the implied volatility of shorter-term put and call options on that index.
As such, the VIX is directly linked to stock market movements, up and down. If options traders expect S&P 500 volatility to rise over the next month, the VIX should rise to reflect that. However, if daily moves in the S&P 500 go from 2% to 4%, that shift to 4% volatility represents a 100% move in the volatility of volatility—which is what you get exposed to if you trade the VIX itself, as opposed to the underlying options.
By February 2018, an unusually large number of investors were trading “vol-of-vol” via products that sold VIX futures. When the S&P 500 shed a few percentage points, the reaction of the VIX was enough to make them de-risk, and volatility markets made them pay heavily to cover their positions—a classic short squeeze.
It was like a tornado causing catastrophic damage to one or two houses while leaving the rest of the financial neighborhood virtually unscathed—including the underlying index and equity options markets that feed into the VIX itself.
Demand for Volatility Control Can Work for You
It is understandable that investors would shy away from “volatility” markets after such an event. In our view, that could be a mistake. As long as there is a structural demand for volatility control from the investment industry, volatility can be the wind in your portfolio’s sails rather than a raging tornado.
Meeting that demand for volatility control involves selling (or “writing”) put options. The important thing to note is that, when that put writing is fully collateralized, the main exposure is to equity risk, with a small premium on top collected from those willing buyers of volatility control. The often-stormy “vol-of-vol” is a very small part of the deal.
What do we mean by “willing buyers of volatility control”? Our industry is measured not merely on return, but on risk-adjusted return, which means volatility-adjusted return. Since the development of modern portfolio theory, asset and risk diversification has been the primary way for investors to improve risk-adjusted return, but pure volatility control requires an investor to buy put options as part of a downside risk-mitigation strategy.
A Good Stiff Breeze
That is why there is a steady market for these derivatives. It is why most put options tend to be more expensive than equivalent call options. And it is why the volatility implied in put-option prices tends to be higher than the volatility eventually realized in the underlying asset itself.
Over the long run, maintaining one-month puts for volatility control has cost investors around 1.5% per month, or 18% per year. Of course, no one does that all the time—but there is usually enough demand to provide that sort of income to sellers of puts, and occasionally a surge in demand pushes the cost of volatility control considerably higher. Right now, the price is some 2% per month. Three weeks ago, it hit well over 3%.
We don’t think it’s hard to decide which side of that trade to be on, especially when we think that volatility is likely to be structurally higher than it has been over the recent past. For sure, if the S&P 500 goes down 20%, that will hurt (although the option premiums received will cushion the blow). If the VIX goes from 15 to 30, it’s just another day on deck—and potentially a boost to the put- writer’s premiums, a good stiff breeze filling the sails.
In Case You Missed It
- U.S. Existing Home Sales: -3.2% to SAAR of 5.38 million units in May
- FOMC Meeting Minutes: Minutes noted that recent data suggest a modestly stronger near-term outlook than anticipated in December
- Japan Consumer Price Index: +1.4% year-over-year (core CPI increased 0.9% year-over-year)
- Euro Zone Consumer Price Index: -0.9% in January month-over-month and +1.3% year-over-year (core CPI increased 1.0% year-over-year)
What to Watch For
- Monday, 2/26:
- U.S. New Home Sales
- Tuesday, 2/27:
- U.S. Durable Goods Orders
- Case-Shiller Home Prices
- U.S. Consumer Confidence
- Wednesday, 2/28:
- U.S. 4Q 2017 GDP (second estimate)
- Thursday, 3/1:
- U.S. Personal Income and Outlays
- ISM Manufacturing Index
- Friday, 3/2:
- Euro Zone Producer Price Index
Statistics on the Current State of the Market – as of February 23, 2018
|S&P 500 Index||0.6%||-2.5%||3.0%|
|Russell 1000 Index||0.5%||-2.5%||2.9%|
|Russell 1000 Growth Index||1.1%||-1.6%||5.4%|
|Russell 1000 Value Index||-0.1%||-3.5%||0.3%|
|Russell 2000 Index||0.4%||-1.6%||1.0%|
|MSCI World Index||0.2%||-3.1%||2.0%|
|MSCI EAFE Index||-0.4%||-3.9%||0.9%|
|MSCI Emerging Markets Index||1.4%||-2.9%||5.2%|
|STOXX Europe 600||-1.0%||-4.7%||0.5%|
|FTSE 100 Index||-0.4%||-3.2%||-5.1%|
|CSI 300 Index||2.6%||-4.8%||1.0%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.0%||0.0%||-0.3%|
|Citigroup 10-Year Treasury Index||0.1%||-1.3%||-3.7%|
|Bloomberg Barclays Municipal Bond Index||0.1%||-0.3%||-1.5%|
|Bloomberg Barclays US Aggregate Bond Index||0.0%||-1.0%||-2.1%|
|Bloomberg Barclays Global Aggregate Index||-0.4%||-0.6%||0.6%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||0.1%||0.0%||1.0%|
|ICE BofA Merrill Lynch U.S. High Yield Index||-0.2%||-1.2%||-0.6%|
|ICE BofA Merrill Lynch Global High Yield Index||-0.3%||-1.4%||0.0%|
|JP Morgan EMBI Global Diversified Index||-0.1%||-2.2%||-2.2%|
|JP Morgan GBI-EM Global Diversified Index||-0.3%||-0.2%||4.2%|
|U.S. Dollar per British Pounds||-0.5%||-1.7%||3.3%|
|U.S. Dollar per Euro||-1.2%||-1.3%||2.4%|
|U.S. Dollar per Japanese Yen||-0.5%||2.4%||5.7%|
|Real & Alternative Assets|
|Alerian MLP Index||-1.8%||-7.1%||-1.7%|
|FTSE EPRA/NAREIT North America Index||-0.6%||-5.3%||-8.9%|
|FTSE EPRA/NAREIT Global Index||0.0%||-5.1%||-3.9%|
|Bloomberg Commodity Index||0.6%||-1.1%||0.8%|
|Gold (NYM $/ozt) Continuous Future||-1.9%||-1.0%||1.6%|
|Crude Oil (NYM $/bbl) Continuous Future||3.2%||-1.8%||5.2%|
Source: FactSet, Neuberger Berman.