The market for volatility just got really interesting

There are currently some obvious sources of market uncertainty—including a contentious U.S. presidential election, and Brexit negotiations yet to begin in earnest—so it may seem strange that the CBOE volatility index (VIX) has been hitting lows. But a closer look at the volatility market tells a more nuanced story.

The current calm belies a stormy outlook

In recent years, the VIX has become one of the highest–profile market indicators, widely used as the primary measure of market uncertainty. But while the VIX is generally a good gauge of the overall state of market expectations vis–à–vis volatility, it’s not the whole story.

In particular, the VIX is based on a 30–day time horizon, so it tells us nothing about how the market is pricing volatility further out than that. And, right now, the market is taking a very different view of volatility over a medium term horizon than it is over the next 30 days: the volatility term structure is exceptionally steep.

The price of 30–day options points to an unusually calm market outlook, with the VIX spending much of last week below 12, close to a multi–year low. But investors looking to hedge volatility on a longer horizon—anything beyond three months—are faced with a very different type of market: a market that Scott Maidel (Russell Investments’ Senior Portfolio Manager, Equity Derivatives) has described as “a bull market in fear.”

This is a reminder that the options market is a rich and complex market. Portfolio managers such as Scott aren’t taking positions based only on the overall market level, but also on variations within the market: puts and calls behave differently; close–to–par options have different pricing characteristics than deep out–of–the–money options; there’s a term structure of pricing across options with different horizons. And when, as at present, those variations become more significant, the market for volatility gets really interesting.

Bonus thoughts: the VIX is not what you think it is

Extra background: I find it notable that, unlike most other widely–followed indicators, not many people know what the VIX actually is. So if you’ve ever wondered “if expected volatility is just the output of a model like Black-Scholes, which makes some very broad assumptions, does it really tell us anything meaningful?” then read on.

It turns out that expected volatility, as captured by the VIX index, is no longer some vague measure of expectations backed out of the Black–Scholes pricing model, but rather a weighted average of actual security values. The CBOE made this change in 2003 (the old approach is still calculated, with the ticker VXO.)

The reason for the change in methodology was to make the index easier to hedge. The CBOE is an exchange: they want people to trade things. And while lots of people want to buy options (which equates to buying volatility), there are not many natural sellers. So the closer the VIX relates to an actual basket of securities, the easier it is for sellers of options to manage their exposures, so the more sellers are likely to be attracted, and the better for the CBOE.

With this goal in mind, the new methodology prices the VIX as a weighted average of liquid 30–day out–of–the–money options on the S&P 500. The clever bit is how this weighted average is based on a portfolio of options whose value at the end of thirty days will equate to the actual volatility of the S&P 500 index over that period. It is far from intuitive that such a portfolio can really exist, so I’ll repeat: the VIX is based on a portfolio of options whose value after thirty days will end up as whatever the level of volatility actually experienced over that period turns out to be. For example, if the S&P 500 flatlines, the portfolio will be worth nothing (that bit is pretty easy: you just need to make sure you only ever hold out–of–the–money options). If there are big changes in the index value, then the portfolio will be worth more. The details of the construction formula (and the rebalancing rules) are beyond my ability to explain here but interested readers can go to the CBOE’s website and really interested readers can go to a very technical 1999 Goldman Sachs research note which laid the foundation for the change in methodology. The key point here is that the VIX is associated with a specific portfolio of liquid options.

Admittedly, while this means that, on paper, the VIX is hedgable, in practice it is not perfectly so: transactions costs are the biggest barrier, along with potential jumps in the underlying index value which can hinder rebalancing efforts. But it has proved to be hedgable enough that it has achieved the CBOE’s goals: trading volume on VIX-related contracts has exploded in the past decade.

Readers may be aware that the actual volatility of the S&P 500 index has long tended to run lower than the VIX. In other words, the portfolio of options associated with the VIX tends to fall in value over time. This tells us that implied volatility tends to be priced high, and hence selling it can be a source of systematic return in an investment portfolio.

I should stop now: this blog is already well over my guideline word count. (Bear in mind, though, that I am an actuary, so if I can’t get chatty about the details of how market indices are calculated, what can I get chatty about?) If you’ve made it to the end, thank you for sharing my wonder at this amazing animal the VIX.