Updated: Jul 30, 2021
Volatility/risk has always been a crucial element of the stock market which was determined by analysing limited historical prices. Once those elements were determined investors and traders could hedge their portfolios using volatility swaps or options. Correcting this market inefficiency led Robert E.Whaley to elaborate a volatility index (VIX) for the S&P100 (now VXO) articulated in “Derivatives on Market Volatility: Hedging Tools Long Overdue”. It began trading on the Chicago Board Options Exchange (CBOE) on April 13th 1993 and was designed as an index that uses option prices to create an estimate of volatility for the next 30 days (calculation method).
There are no sales, no quarterly reports, no profit/loss, no PE ratio, and no potential for any dividends (Harwood, 2019). It is a metric for broad investor sentiment and market volatility also known as the investors fear gauge Whaley (2000) which represents how traders assess risk any time over the next 30 days.
By looking at figure 1 we can assume an asymmetric relationship between SP500 and the VIX (DeLisle et al,2011). This is due to option premiums moving inversely to the market.
If the S&P500 is rising, stock prices tend to be less volatile and the premium for buying/selling options low, this equates to a low VIX.
On the other hand declining markets tend to cause uncertainty and anxious trading behaviour. This leads to an increase in volatility and an increase in option premiums (i.e market insurance). Much of this increase occurs when worried investors pay a large premium on puts to protect their positions (Harwood, 2018).
Or simply put:
-When things are going well with little upcoming changes, the index will shrink.
-If sudden changes in market conditions occur, you will see a spike in the VIX.
Some geopolitical tensions are also reflected in the VIX which historically mean reverts to approximately 20 (Figure 2).
In the past the VIX dropped with greater frequency and magnitude when elevated than it has increased when at depressed levels (Stephen Marra,2015). This in turn suggests that there is a negative relationship between returns and volatility (figure 3).
Many studies have examined the unique properties of the new VIX index. To name just a few:
1- In “Day-of-the-week effect on the VIX. A parsimonious representation“, Qadan, Gonzalez-Perez, Guerrero (2013) report that the VIX tends to rise on Mondays, fall on Tuesdays and Wednesdays, rise on Thursdays and shows no significant change or slightly increases on Fridays (without controlling for outliers).
2- In “Time-variation in the impact of news sentiment, implied volatility and stock returns”,Smales (2014) observes a strong negative relationship between changes in VIX and aggregated news sentiment. It states that:
“The magnitude of response to negative news is greater; however, when volatility (the level of investor fear) is low the response to negative news is insignificant at an industry level. On the other hand, when volatility is high “the firm specific news appears to play little part in determining returns, it is likely that during such periods systemic news plays the dominant role in the minds of investors”
3-Other securities for instance the VVIX (volatility of volatility), although not directly tied to movements in the VIX have predictive power for VIX options returns as detailed in “Volatility-of-volatility and tail risk hedging returns“ (Park 2015). The range of values of the VVIX is at a significantly higher level than that of the VIX and tends have stronger mean reverting properties. This VIX on steroids is mainly used in delta hedged strategies which are standard risk management technique of option traders (Hull 2011).
The rapid success of the VIX lead the CBOE to develop VIX futures in 2004 and VIX options in 2006. Those more complex asset have lead the path to many volatility indices, some of which are listed in figure 4.
Those volatility-related trading instruments provide traders and investors access to exchange-traded tools for hedging and taking long or short positions to expected S&P 500 volatility, preferably for a short time period.
Other securities designed to track volatility include exchange traded notes (ETN) or exchange traded products (ETP) which is unsecured debt security issued by a bank. Remember that by buying those derivatives you will not own the underlying asset that the security tracks. Some ETF’s and ETNs magnify the performance of the underlying security by using leverage.
For example This allows you to take a bearish position on a trade without having to go through the process of actively shorting the underlying security. The majority of these “geared” ETFs are issued by ProShares and Direxion. On the other hand banks will typically issue ETN’s/ETP’s, mainly Barclays, Credit Suisse and UBS who take a small fee, generally less than 1%.
The most popular products for going long or shorting the VIX are:
SVXY provides inverse exposure to the VIX. (AUM:$541.52M; Average daily volume:$280.03M)
UVXY provides positive leveraged exposure to the VIX (AUM:$950.81M; Average daily volume:$581.58M)
Those include big roll costs, hefty expense ratios and are not long term investible assets.
Such volatility derivatives have gained popularity over the last few years due to their liquidity efficiency and hedging benefits. With leverage comes a higher rolling fee therefore it is recommended to close your position within days.
VIX Mean reverting strategy
The VIX index shows a distinct mean reverting pattern (it generally returns to its historical average), it oscillates between short term spikes and less volatile periods
This suggests that the higher the VIX peaks the shorter time it takes for it to decrease (figure 5). Therefore shorting the VIX or “short vol trade” when it peaks is a common trade.
Tastytrade network (link) figured the average number of days it takes for the VIX to mean revert after it peaks in figure 5
Prior to entering such a trade it is important to have a good understanding of the current economic environment to better assess the trade. There were periods historically where volatility stayed elevated for years and we do not have enough data nor experienced enough peak to mean scenarios to accurately predict such a sensitive trade.
Large institutions seem to have increased reactiveness to shocks in the market suggesting a shorter peak to mean time in the future.
Bear in mind that implementing such a trade is time sensitive and requires to take a short position when uncertainty and fear is at its peak without mentioning the fact that your portfolio is probably experiencing sever loss. Prices can continue moving away from the mean for longer than expected. On top of that there may be other more profitable opportunities in times of turmoil. For those reasons a strict risk management protocol should be set prior to entering a trade.
Some notorious volatility trades
occurred on February 5th 2018 when the S&P 500 dropped 4.1%. This lead the VIX to increase 115% (from 17.31 to 37.32) which rippled on to volatility derivatives.
This event is known as Volmaggedon which raised concern on leveraged ETP’s and ultimately the end of XIV which lost 95% of its value in about 15 minutes. You will find more explanations in “Volmageddon and the Failure of Short Volatility Products” (2021). This in turn has led to some spectacular trades:
Houndstooth Capital Management, LLC scored a 6,000% return on its volatility related gamble (Peterseil and Waite, 2018). The hedge fund achieved this by buying put options on XIV, which tumbled 83% during a record one-day spike in volatility in February of 2018 “ (link)
Prior to February 2018 an anonymous trader “50 cent” continuously bought 50 cents on 50,000 VIX contract call options trades with his position reaching up to $200m in profit (link) (figure 6)
LJM Partners Ltd is a prime example of excess leverage in volatility products. Prior to February 5th 2018 LJM Partners Ltd had a short vol position by purchasing XIV until the VIX increased 115% which led LJM to lose 80% of its value that week (link). Eventually XIV (Figure 7) was removed by Credit Suisse for it was deemed too dangerous.
On the crypto side of things
The crypto volatility index (CVI) may be an equivalent to the VIX which tracks the 30-day implied volatility of bitcoin and Ethereum. Although it is still inefficient and illiquid it is rapidly developing along with other crypto derivatives (DeFi) which continues to mature.
Ultimately, volatility securities are used by professionals to hedge and speculate on investors market outlook. They play an important role in the pricing of derivatives, trading and risk control strategies.
As options trading has gained popularity among retail investors it is important to understand this unique approach to protecting one’s portfolio. You should read the instrument’s prospectus before buying sensitive volatility derivatives. This will give you more information regarding the pricing, roll cost and overall risk disclosure.