Schaeffer's Market Mashup: Volatility Strategies with Cboe Global Markets

Breaking down the risk-on/risk-off environments in 2020

Managing Editor
Dec 16, 2020 at 2:21 PM
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On the latest episode of the Schaeffer's Market Mashup podcast and the last episode of the year, Patrick brought in Scott Phillips, Lavaca Capital’s Founder and Chief Investment Officer and Matt Moran, Head of Index Insights at Cboe Global Markets. Patrick, Scott, and Matt chat about risk-on/risk-off environments in 2020 (1:30), "Greek" talk (10:20), and options strategies amid volatility spikes (16:02).

Transcript of Schaeffer's Market Mashup Podcast: December 17, 2020

Patrick: Ladies and gentlemen, welcome back to the Schaeffer's Market Mash up. This is possibly the last market mash up of 2020. Let's finish strong and get right to it. Volatility ever present and can change at the drop of a hat. So obviously we all remember early to mid-February, how we all felt about life in stocks and general, and then come March a month later, the S and P 500 lost a third of its value due to the pandemic. Today I'm joined by Scott Phillips Lavaca capital's founder and chief investment officer Scott, welcome. 

Scott Phillips: Thanks Patrick, good to be here. 

Patrick: And I also have Matt Moran head of Index Insights at CBOE global markets Matt, welcome. 

Matt Moran: Thank you, Patrick. 

Patrick: And today we're going to discuss how traders can use options as a tool to empower our inner Warren buffet, who has the famous quote of "it's to be fearful when others are greedy and greedy when others are fearful". I want to set the stage first by explaining the difference between a risk on and risk off environment to our listeners. And I know Matt and I were talking about this before we aired and 2020 is tricky. You know, the growth stocks were doing well while the value stocks underperformed, which is sort of the inverse of what the risk on and risk off environment implies. And then of course there's been rotations within the year. Matt, can you start to unpack that for our listeners just to start off?

Matt Moran: Sure. Well, if we're talking about the question of risk on versus risk off in 2020, it's not, maybe not quite as crystal clear as you might expect in that. Certainly if you're talking about risk on what I think about, I've been reading about risk on, you're talking about a situation where investors have an aggressive growth oriented feelings about the market. Whereas the risk off environment, you're talking more about more of fear in the market and more of a focus on safe havens. So what do we have this year? Well, you had a situation where the market early in the year was starting to go up, but then concerned about COVID basically hit worldwide. And by March you had a situation where the CBOE volatility index, ticker symbol VIX, very, very well known. It's all time daily closing high at 82 point 69.

That was in March, and certainly you could say, well, that's got to be a risk off environment. There's got to be, people have got to be fleeing for safe havens, but what you did see in subsequent months was people were looking at different sectors and different opportunities. And certainly different sectors, different industries out there did perform in very different ways and that energy was weighed down. But you did have some tech stocks and whatever, actually not, actually doing pretty well. And so you could say, well, it depends on what sector you're talking about, but certainly we did have, we have had an interesting year in terms of the risk on and risk off attitude on investors.

Patrick: its hyperbole sometimes to say it, but this year has been so crazy as far as what to expect. It's always worth breaking it down a little bit more. Scott, do you have anything to add?

Scott Phillips: Yeah, certainly. So, you know, to us, it just, it all comes down to investor expectations and what we're actually seeing price-wise in the various assets that trade globally. So, you know, Matt mentioned a bit to safe Haven assets. You know, typically a risk-off environment will be marked by something like that, where you have a bid to treasuries, a bid to those global government type securities particularly in the US. They kind of mark a traditional risk off environment you know, fast forward that towards more of the volatility side of things. And as Matt mentioned, you can see that present in the bit, right? So Matt mentioned the Volatility Index, the VIX and the S and P 500 and what that is particularly doing and how quickly that's changing.

And so you can look at a VIX of 85 as Matt mentioned, and certainly say that that would mark somewhat of a risk off environment. But high volatility doesn't necessarily, at least expressed in high VIX terms; it doesn't necessarily mean a risk off environment. So fast forward to the most recent month where by historical standards the VIX was still elevated in the period of November, but we had one of the strongest equity performances in quite a while. And so, you know, that pairing between what the volatility index is doing, what all the other asset classes are doing in terms of price movement that really helps define what a risk on or a risk off environment may be.

Patrick: Okay. That makes sense; I'll stick with you here. Is it as easy as considering a period of high volatility strictly when the VIX is above 20?

Scott Phillips: Yeah, that's a great question. You know, I would say if this was 2017, certainly a VIX of 20, would mark a higher volatility regime. And I think that you need to break it down by different time periods to kind of look into what high volatility, low volatility, average volatility really is within those different "volatility regime". So historically over the full Matt, what was it? 1990, 1992 that the VIX launched?

Matt Moran: The data on the VIX go back to January of 1990.

Scott Phillips: Right. So back to 1990, January, 1990, if you look over that full period, the VIX has averaged about 19. We've certainly had periods much lower than that, and much higher than that. The most recent March [unclear 06:22] the highest VIX level ever. And like I mentioned, 2017, I believe we had the lowest VIX reading ever in 2017. But historically has an average of around 19. And it has a range that it typically moves in of plus or minus eight points. So if you look at the standard deviation of the VIX movement, including all of these outlier events, which certainly skews some of the data the VIX typically moves plus, or minus eight points from that 20 point or that 20 or 19 average. 

And so when we think about, you know, what's a higher volatility regime, I think you got to dial in to the different time periods that you're looking at, because, you know, this year 20 is in the high VIX, right? That isn't necessarily a high volatility regime but in 2017, it may have been for that period. And then also look at that in the greater context of the overarching time period of that full history. And you can even utilize some of the S and P price movement and go back and extrapolate what the VIX would have been say on black Monday, right. Or what real life volatility would have been on black Monday back in 87, and really begin to get a better picture of what is considered "high volatility".

Patrick: Yeah, that's very helpful. Matt, do you want to expand on that?

Matt Moran: Yes. Well, you might say, well, high volatility, low volatility; VIX is above its long-term average. That's all nice, but how does this impact investors? And I would say this, that if you were in a higher volatility regime, let's say where VIX is around 30. Well, you have a situation where at least for some investors that might go to risk off where they might say, I'm going to look at safe Haven investments. Well, the challenge you have right now, though, is if you're looking at safe Haven investments like Treasuries, for example, the interest rates on those treasuries are extremely low. And you could say, well, actually, maybe that really isn't that safe and that if these interest rates are so low and there is the risk of the interest rates eventually going up. 

Maybe you could even lose money on these treasuries, but anyway, it's not a great place to be arguably. So what are the alternatives if VIX is high? Well, another thing to keep in mind though, if the VIX is high. If you were to go out and sell index option for example, there is the possibility of generating more options premium. And for example, at CBO, we do have several benchmark indexes and for example, we have the well-known DXM Bi-Rite index, and that goes out and sells one month option. Sells one month, 30 day at the money that's BX options and research does show that, for example, if you go out and write the options, when VIX is around 10, you're only generating about 1% per month, which comes out to about 12% for your gross premium. 

So that's pretty good but if the VIX is at 30, you generate about 3% per month 09:26  over 30% per year in gross premiums. Now, I do want to stress and talking just gross, not necessarily net, obviously the premiums you generate on an option writing strategy are all positive. It is possible, particularly in a bear market that your option writing position could actually take a drop. Anyway, the whole idea of generating more options premium with option selling strategies in times when VIX is high can be pretty appealing. And in my mind could be certainly considered by investors who are concerned about this low interest rate environment right now.

Patrick: I want to run with that a little bit and help me understand what is going on when volatility is rising. We know the price of an option is affected of course but there's more to it than that. And I'm thinking of the Greeks, which I've been in this business now for three years, and I'm only just starting to understand. So Scott, and then Matt unpack that a little bit more for me,

Scott Phillips: Certainly. Yeah, so there's different pricing components that make up the overall price that you see listed there on your screen when you're buying or your selling an option. Those are what's known as the Greeks and there are various first and second derivative Greeks that affect that option price. So go back to your calculus days a little bit here we first mentioned volatility being impactful to the overall pricing of an option and that's certainly true. That Greek is called Vega, and Vega is the amount that an option price will change based on a one point change in the underlying volatility of that instrument. So if an option has a Vega of 20 and the volatility rises at one, then you would have that corresponding change I should say 20% corresponding change to the overall option price.

So when we see periods of higher volatility, we get higher prices and options. When we see periods of lower volatility, we see lower prices and options. And so there's a direct impact by that amount of volatility change to the overall price. Other Greeks, that you may be familiar with the Delta Gamma and the life there's several others that I could go into, but those beta being kind of the fourth one, those four would be the four major. Just to break them down a bit more, we talked about Vega, Delta would be the change of an option for a change in the underlying price of the stock. So you're looking at S and P options Matt mentioned, a $1 change in an S and P option with a Delta of 30 would have a change to the option price of 30 cents.

Patrick: Okay. 

Scott Phillips: When we look at Gamma, Gamma is the change of Delta meaning that for every change that that market or that underlying instrument changes in price we reset the Delta to those different levels. And so I kind of liken it to driving down the road, so Delta is how fast you're going down the road while gamma is a Mount that you're changing, you're accelerating or decelerating as you're going down the road. I think that gives a pretty good depiction of how your Delta changes in respect to the option price and the underlying stock price. And then lastly would be Feta, Feta is the price, are the decay of an option price, and how that price, that option price will change as time passes. So Feta is the time passage component of the option price.

Patrick: Okay. Now my eyes kind of glazed over after you said, go back to your calculus days, but you brought me back with the driving analogy and that does make a little bit more sense to me. Matt, do you have anything to add?

Matt Moran: Yes, I'd like to pick up on just one of the concepts that's Scott mentioned feta or time decay and I'll put this in hopefully somewhat simple to understand language. When we came out with a BXM, Buy-Rite index early in this century, a lot of money managers at the time would write options just maybe once a quarter, right and write them four times a year. But then we came out with the BXM index with the whole concept. Well, how about writing more frequently? How about writing once a month? And the advantage of doing that running 12 one month options versus four, three month options is the fact that you are taking advantage of this option seller anyway, is taking advantage of time decay or Feta in that time decay or Feta helps the option seller, the closer you get to expiration.

So the thought is that roughly one should collect about twice as much premium writing 12 one month options as with four, three month options. Furthermore, in recent years, we've come out with weekly options. And certainly managers now are starting to look at that and looking at even shorter time periods. And so, for example, some managers actually do write options multiple times a month. I think some people sometimes suspect, oh, are they just doing that to speculate? No, they're doing it to take advantage of time decay or theta. And we now actually do have an index WPUT that does go and write in cells as PX options, 52 times a year. And the thought there in general is the fact that theory serious that, well, you write 52, 1 week options as opposed to 12 one month options. The goal there is to generate even twice as much premium as writing less frequently.

So anyway, the thought is that if you go out and write more often, that there is potential to generate more gross premium one morning though, is the fact that while you've really got to, you really should know what you're doing. Some people I think would say, well, you should maybe leave this to professional investors and certainly can invest in funds who are managers are able to access these concepts and these goals. But anyway, Theta and time Decay certainly is a very interesting concept that more and more options sellers are taking a close look at with the idea of generating more options premiums. And we do have an index now, ticker symbol WPUT again, that writes SPX options once a week, 52 times a year.

Patrick: I want to pivot now over to options strategy does a market participant always have to change their strategy when volatility rises, what's a formula, or at least some basic guidelines that they should be following to stay in the game? Scott, you can take that one first and then Matt can finish up.

Scott Phillips: Yeah. I mean, different environments call for different structures, you know, to us at the end of the day; an investor has to form a thesis, right. And you have to have a thesis, and then you have to make a decision on that thesis, that's how you're going to express it, right. So if you think that a stock is going to go up you may look to purchase a co-option, right. Very similar, if you think that a stock is going to go down you may purchase a put option a as a way to express that thesis, but everything ties into having a core thesis and a way to express that thesis. What we like about options is that they give you multiple ways to express that thesis. So you can get creative in how you're looking to express that thesis, and you don't have to have just a linear type return profile to your, to the strategy that you're using.

So, you know, step back to March this year, you know, an investor may have looked at the time period in March as a really extraordinary time period. You know, determining that those 10% daily moves that we were looking at you know. I think we had one that was over 10% and I note several in the seven to 10% range that those types of moves just weren't sustainable, right? And maybe that investor had purchased a put option to protect their portfolio you know, maybe a month or two before that. Maybe, you know, back in January when COVID first started appearing on the scene yet the equity market continued to rise. They decided to purchase that put options to try to hedge their downside exposure and their equity portfolio at least. 

And so fast forward to the week of March 23rd, when the equity markets bottom that put options that that investor had purchased benefited two fold, one had benefited from the price decline. If they still, if they had a maturity that went through that period had benefited from the price decline. It also benefited from the expansion of volatility that we saw. So Matt mentioned that 85 VIX I believe, you know, ahead of this, we were at 13, 14 and the VIX all the way up to 85. So you had a very, very large increase, I think Matt correct me if I'm wrong, I think that was the sharpest rise in the shortest period of time in the VIX that we've seen since the nineties. So pretty extraordinary, pretty significant historically type of period that we experienced there. 

And an investor may have utilized that opportunity to protect, to perhaps monetize their hedges so the PUT they purchased, they could have been sold into that type of event. So I think when you're looking at the environments and you're looking at how different environments impact your strategies, it comes down to your thesis, right? If it's protective and nature, like we just walked there or maybe it's more yield in nature, like Matt just mentioned. So potentially looking to sell some type of option to generate a type of yield, this other strategies that people implement based on different regimes. And it all goes back to those volatility regimes that we've mentioned at the beginning of the, of our time together. Yeah. 

Patrick: Yeah, that makes sense. Matt, do you have anything to add, or do you want to kind of build on some other factors that you are considered for an option strategy?

Matt Moran: You know, I think your question was in regard to what do you do when options volatility, rises? And this is kind of a key point from my point of view, in that I believe a lot of investors out there are saying, well, I'm not going to put on protection unless until the market takes a big fall. Well, one of the challenges right away though, is the fact that, well, the market takes a big fall in general, and the VIX price is going to go up. And so the cost of your hedging could be quite a bit higher and so if we get back to the statement, you mentioned earlier, as far as Warren Buffett said, be fearful when others are greedy and greedy, when others are fearful. The problem with buying protection, when the market is going down is you're being fearful when others are being fearful too.

And that can be a little expensive. And so you do want to keep that principle in mind, you want to keep in mind what your goals are, and if your goal is long-term capital protection and avoiding big drawdowns. You might think about, well, maybe I want, you might want to put on some protection when the VIX actually isn't that, isn't near its all-time highs. And recently we did have a webinar featuring a major Midwestern endowment that said that, yes; they devote 2% of their allocation to hedging types of strategies. With the realization that the vast majority of the times, these hedges are not going to pay off, but the hope is, and years like 2008 and 2020 that the hedges really can pay off and can help smooth out returns. And so again, I'd say, keep that in mind and certainly when volatility rises, that does impact the implied volatility and it can impact both option buying and option selling strategies, Patrick.

Patrick: Okay, great. Well said, Scott, did you have anything you wanted to expand upon when you were talking about objectives and a little bit more about risk tolerance.

Scott Phillips: Yeah, certainly, you know, Matt brings up some good points here and, you know, by having that safety net so to say in the form of a PUT option potentially in the example that we're discussing now. It really allows an investor to manage their emotions, right. It's you know, when we were talking earlier, Patrick, you know, I mentioned kind of the seatbelt analogy and it really, you know, I really kind of liken it to getting in your car and putting on your seatbelt. You don't ever want that seatbelt to activate. You never want that to be the scenario but it's there just in case, right? And it can be a lifesaving type feature in your vehicle, safety feature in your vehicle, in the case of an impactful crash or, you know, God forbid something horrendous happening, right.

It can really be there to save your life, same thing of a PUT option and portfolio. You never want them to pay off, right. When somebody buys a PUT option, unless they're speculating, if they're using to hedge it, they don't want them to pay off, right. And all the best worlds the market goes up, yeah they lose the money that they spent on the footprint [unclear 22:41]. But their stocks went up in price, right. And so they essentially made money that way versus the market declining and that being really impactful on that drawdown being really impactful, not only to their financial state, but to their emotional state. 

So if you look you know, right now the price of the PUT option out in the four to five month range may run an investor 2 to 3% when using an out of the money option to protect the portfolio. Yes, that is a cost to their portfolio and will be a drag if the market goes straight up between now and that time period. But it's a safety net for them and it gives them some peace of mind. And just to kind of add to what Matt say, you know, you really want to look to hedge these positions or to utilize these when you get the cheap opportunities. And then potentially profit from them when things get a little bit dicier.

Patrick: Yeah, I love that seatbelt analogy. From a personal standpoint, I always liked wearing my seatbelt don't you want to enjoy a ride knowing that you are safe and secure. You, never get a better sleep than knowing that peace of mind. Just, it always made sense to me to have that insurance locked in. Another personal example completely out of that field, but I purchased PGA championship tickets for Kiawah Island back in November for May. And it said, do you want to buy, you know, insurance for these tickets because of the pandemic? I said, of course, you know, now I have no worries about, are they going to allow fans or not? And you know that peace of mind, I think, is very integral to an investing strategy, especially when it pertains to options. Scott and Matt, I want you both to give the best advice you've received when making capital allocation decisions. Scott, you can go first and Matt, you can wrap it up.

Scott Phillips: Yeah, I took the best advice that I've received is to always protect your downside you know, by managing your draw down risk. You know, we talked about the emotional toll that a significant draw down can have on an investor, managing that risk potentially through the use of options can really allow you to emotionally weather that market volatility when things inevitably go array, right. It does seem like more and more so over the past several years we've had more episodes not maybe to the extent of March. But we've certainly have had sell offs that have come by surprise to many investors or caught many investors by surprise. And it really gives you that ability to kind of stay invested you know, knowing that you have the, have that protection on you know, the well-known secret, I guess to being consistently profitable is really limiting your downside.

And to us, you know, as I kind of look at the world, that's exactly what a PUT option can offer. Certainly it has its own implementation challenges, right? That an investor needs to know what they're doing when utilizing these instruments just don't take me, don't, you know, don't take me wrong. Any of these instruments require a significant amount of investor education before utilizing them, but an investor. You know one of these tools at the hands of a well-educated skilled investor can be a highly, highly useful tool in their portfolios.

Patrick: Well said.

Matt Moran: Well, in conclusion, one of the things I'd like to point out is the fact that Warren buffet is going out and actually certainly looked at the idea of collecting premium. He's gone out and bought several insurance companies whose main business is to collect premium. Another thing he's done though, too, is to go out and sell long dated OTC index options is collected upfront premium of $4 billion. So the whole idea of going out there and selling options, collecting premium certainly has been strongly endorsed by Warren buffet of all people. And at CBO we have a lot of resources if you do want to look in this concept more, as far as selling options premium, taken advantage of that, taking it into some premium that can help smooth out returns, generate more income for you. 

We do have several resources. So the resources would include bench mark indexes, such as the BXM, and the BXMD Bi-Rite indexes, and also the PUT, PUT write index. So we've got these indexes out there also in 2020, the Wilshire analytics firm, a firm, which has 20 I'm sorry, 1 trillion in assets under advisement. That firm has actually published three different papers and the whole idea of going out there and selling richly priced options premium to help smooth out returns. Hopefully generate some good risk adjust to returns. So there is quite a bit of research out there to help you out when you do try to attack these ideas and try to get a better handle on how can I generate more premium in times of low interest rates. So thank you very much for the opportunity, Patrick this has been a great call today.

Patrick: Yeah, thanks Matt. I mean, that's outstanding I, honestly I wish we can. I have a thousand more questions for you guys, and I can run up two hour podcast here. Thanks again, both of you guys, Scott Phillips Lavaca Capital's founder and chief investment officer down in Houston, best of luck with those ailing sports franchises.

Scott Phillips: Had to get the plug in.

Patrick: Had to get one little, I forgot in the intro. So I was like, alright, make sure I get the jab in at the end. And then Matt Moran, head of Index Insights of CBOE global markets. Matt, I have no qualms with any Chicago teams, so you get off free today. 

Matt Moran: Okay, sounds good. 

Patrick: Thanks again, guys. Stay safe out there and hopefully we can maybe revisit this conversation down the road because like you guys have both said there is so much to talk about here and we're really only just getting started.

Scott Phillips: Right.

Matt Moran: Okay, thank you Patrick. 

Patrick: Thanks guys. 

Scott Phillips: Thanks Patrick thanks everyone. 

Patrick: Cheers.

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