Breaking Down the Current State of the Volatility Market

How VIX weeklies have changed the game, and more

by Adam Warner

Published on Dec 2, 2015 at 10:34 AM

There's a Chicago Board Options Exchange (CBOE) volatility shindig going on now in Hong Kong. It's a little bit outside my paper route, so I'm not attending. But we do have several updates via the CBOE options hub website.

Buzz Gregory of Goldman Sachs had some interesting things to say on the current state of the volatility market, which we can go over in bullet point form:

"It was noted that both SPX and VIX option volumes continue to steadily grow with volume experiencing dramatic increases occurring around market events."

I'd note it also spikes wildly around CBOE Volatility Index (VIX) expirations, but that's a topic for another day. Is the relative spike around news (say, an anticipated Fed meeting) greater nowadays than in the past? That I'm not sure about. It's a tough data set to analyze, as not all news events are of equal magnitude. Though I suspect we do obsess more over certain anticipated news, and it's logical that would translate into greater options volume spikes.

"About 36% of SPX option volume occurs in contracts with 10 or fewer days to expiration and just over 50% of VIX option volume occurs in the front month contracts."

It's pretty amazing to see how weeklies have transformed the way we trade options. Regular monthlies expire either every 28 or 35 days, so basically two-thirds of the time there were no options that close to expiration to even trade. As for VIX, frankly, I never understand a play beyond the front month -- at least, I never understand a play that goes long VIX out in time. If you anticipate a vol spike, play for it in the here and now, in my humble opinion.

"VIX tends to trade at a premium to realized volatility with the average spread being about 4 volatility points."

I use that 4-point premium as a guideline. Glad I'm not alone ... though I was pretty sure I didn't just make it up.

"He spent some time equating VIX to the economy and noted that VIX is higher during recessions stating that the average for VIX during recessions is around 26 while it is 17 during periods not experiencing a recession."

VIX does trade in regimes of about four-to-six years. We're likely in the early stages of transitioning from a low regime to a high regime. I never really thought about how it corresponds to recessions and expansions, but I guess it makes some sense. We saw high VIX in the late '90s into 2003, and again from 2007 to 2010-ish, so there was some overlap with recessions. I'm not sure the investing of this, though, as VIX is more reflective of the recession than predictive.

"When discussing structuring a VIX trade he noted four factors to consider -- S&P 500 returns, term structure premium, volatility risk premium, and mean reversion of VIX versus its long term average."

Very true. To me, the volatility risk premium is perpetually too high. If you have the capital and the willingness to act as a de facto insurance company, it's going to pay overtime to fade those overpaying for "tails."

"With respect to using SPX or VIX options to hedge a portfolio Buzz noted that it is not necessarily an either/or decision."

I tend to believe straight puts offer a better deal than VIX paper. But specifics do matter. And there's no reason you can't mix and match the two. The iPath S&P 500 VIX Short-Term Futures ETN (VXX), for example, behaves very much like a standard index put option. They both decay over time, just for different reasons.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.


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