As I write on June 16, the CBOE Volatility Index is trading
at 25.87 – down 10% on the day.
The Vix is the 'fear gauge’ that measures the
prices of in-, at- and out-of-the-money calls and put options
on S&P 500 shares. The implied volatility it measures is
inversely correlated with underlying equity prices.
It may seem natural, then, that today’s drop in
the Vix is commensurate with recent gains in equity markets.
Having rallied for six days on the trot, the S&P 500 is
putting together its longest winning streak so far in 2010. And
since rising markets exert a downward pull on the Vix, this
rapid plunge in the Vix seems par for the course. But
The up and down surges in recent months of implied
volatility – one of the most important elements of
option pricing – are far from ordinary.
Take a look at the left hand graph below. It shows, for the
period March-June 2009, on how many days the Vix moved by a
certain percentage, up or down. What you’ll notice
is that the most common result, on 26 out of 61 working days,
was a modest 2%-5% fall in the Vix. So far, so normal,
considering that during those months the S&P was rising
Fast forward to the present (graph 2), and
you’ll see a very different picture. And maybe not
the one you were expecting.
It’s not so much that the Vix has changed
direction – in geek-speak, swapped from a positive
skew (counter-intuitively, this means a pattern of falling more
often than rising) to a negative skew (vice versa).
It’s that the range of outcomes has become much
more varied. The distribution extends further from the midpoint
in either direction, and with more outlying events. This is a
classic example of 'excess kurtosis’, or, to use
its stage name, the 'fat tail’.
Fat tails, as popularised by The Black Swan author
Nassim Nicholas Taleb, are events occurring outside the
ordinary. And in the Vix, they are happening far more often now
than they were 12 months ago.
These fat tails are causing some very unusual outcomes for
investors. The extreme rates of change in implied volatility
are producing some truly bizarre goings-on in options
Just last month came a particularly weird example –
equity call options that rose in price while the stockmarket
was selling off.
Hysterical Thursday’s hysterical
The 'flash crash’ on May 6 – dubbed
Hysterical Thursday by Bloomberg BusinessWeek magazine
– has spawned many important talking points.
Equity market grandees have attacked the role high frequency
traders are said to have played in the rout. But the figures
from that fateful day reveal something just as puzzling.
The S&P 500 Index fell 3.2% from 1165 to 1128 on the
session. Thus, it was a day when one would expect a long
options portfolio to take losses. But that was not to be.
Equity call options began to fall upwards.
Take Procter & Gamble. Our example is the $70 October
contract. With three months till expiry, it was three strikes
out-of-the-money, as the share price had closed at $62.16 on
On May 6, P&G shares plummeted to as low as $39.37 in
the afternoon, before closing at $60.75, down 2.3%. On a
horrific day like that, it’s unlikely that any
holders of this 12% out-of-the-money call were expecting a bump
in their contract’s value. However, the
call’s price actually rose 20% by the
And P&G was not the only one. Kraft, Pfizer, PepsiCo and
Abbott Laboratories were among the plethora of companies whose
calls were also falling up. Abbott Labs’ call
premium rose an eye-watering 146% in the $60 strike, though the
shares fell from $50.15 to $49 on the day, via a low of
Then, the storm of volatility vanished as quickly as it had
come. The Vix’s rise to 40.95 on May 7 was
countered by a fall to 28.8 on May 10. That’s a
26.9% fall after a 24.8% rise in two sessions – "the
largest single day decline in the 17 year history of the Vix
and in the 20 years of reconstructed Vix data," to quote
Barron’s commentator Bill Luby.
The week of the flash crash, naturally, was one of the most
extreme cases of such anomalies – but not an isolated
one. Excess swings like this, as the graph shows, are more and
Another instance of this type of rogue optionality occurred
in 2008. Dean Curnutt, president of Marco Risk Advisors, has
written in his daily note to clients on one of his favourite
anecdotes from the financial crisis: "We were buying calls on a
customer’s behalf as a financial stock crashed.
Despite the stock in seeming freefall, the value of calls was
actually rising rapidly – that’s not
something you see every day."
Stampeding this way and that
Just as in 2008, the market is now trading wildly.
Correlation – a factor input of volatility –
is rising, both between otherwise unrelated stocks and between
The implied correlation index on US stocks has risen 21% in
the last four months. This demonstrates that investors are
thinking in binary terms – every signal is interpreted
as good or bad, buy or sell, risk-on or risk-off.
Under the hood of a rogue option:
Procter and Gamble’s vega
To see what's going on, look at the intraday
volatility graph for a Procter & Gamble $70 October
call on May 6 (source: Bloomberg).
What you'll see is that at 2pm on the day in New
York, P&G’s implied volatility
suddenly starts to bump upwards from 17.50 to 18,
before going into a steep climb between 2.40 and
3.10pm, hitting a peak of 21. During the course of the
session, it rises nearly 20%. That was enough to make
the option price rise from about 0.50 to 0.60 on the
day, with a peak of 0.70, even though the share price
Separating the components of this rogue option
reveals a fascinating quirk.
Time value is immaterial, since the option is 136
days to expiry. Interest rates are of marginal
influence at the best of times.
It is the underlying share price, implied volatility
and their partial derivatives that are dictating terms
in this trade.
The call option’s delta, or sensitivity
to share price changes, is overwhelmed by its vega, or
sensitivity to change in implied volatility. This is an
extreme example of positive vega risk.
While severe price declines are bad news for
shareholders, the extreme sensitivity of implied
volatility’s relationship with that price
has benefitted these option holders and many more
Paradoxically, if the share price had risen, the
options trade would have had a similar outcome. The
option premium’s delta gain would have
outweighed the fall in implied volatility, which was
already at 12 month lows. Whatever the weather, these
particular options were set to rise.
This bizarre range of outcomes has been hell to trade. To
quote Jim Cramer, the excitable host of CNBC’s Mad
Money: "Let’s speak truth... People hate this
market. I hate it. You hate it. Everybody I talk to hates it
because it’s one way each day, not connected to
any other day."
But hating the market is not enough. We need to understand
why this is happening and what we can do about it.
I have a few theories as to why the market is behaving so
Theory 1: It’s just noise
One could take the view that today’s fat tails
in volatility are just a natural result of the changes in the
stockmarket in the past year.
The Vix is a mean-reverting index. Implied volatility tends
to overstate the realised historical volatility experienced.
Besides, if volatility did not revert to mean, and was a
trending force, we’d have 15% moves in the S&P
So whenever the Vix is at historically high levels, the next
big move is more likely to be down than up. Twelve months ago,
implied volatility was still coming down from the all time high
of 81 that it touched in late 2008.
Therefore, it should be no surprise that in the second
quarter of 2009 it was falling fairly steadily.
And now that it has reached a lower base, closer to its
mean, it is trending less strongly and bouncing up and down
But this argument fails to account for the fact that the Vix
is a lot more choppy now than at other times when equity prices
have been moving sideways, such as in 2005-6, or even during
the boom and bust of the late nineties and early noughties.
Theory 2: Trading in the dark
The rapid changes in volatility could be a consequence of
the dire economic outlook.
This is a tepid economic recovery, with no consensus as to
what is coming next. Economists, analysts and business leaders
can’t seem to agree on anything. Depending on whom
you listen to, now is the time to ramp up dividends and buy
back shares, or go on an M&A spree, or remain heavily
overweight in cash.
This makes for a severe lack of visibility for traders and
investment managers. And when you don’t know what
tomorrow might bring, you’re more likely to
over-react to what’s happening today.
Five days of supervolatility in the past 12
1. 'Dubai World/Nakheel’ on
The Dubai government announced that Dubai World
"intends to ask all providers of financing to extend
maturities until at least May 30 2010". The Vix rose
20.8% in the session.
2. 'Greece One’ on January
Credit default swaps on Greek debt rose to 340bp after
the ECB warned that no member nation could expect
"special treatment". The Vix rises 22.6%.
3. 'Goldman/SEC’ on April
The SEC tabled a fraud charge against Goldman
Sachs over its role in structuring a CDO tied to
subprime mortgages. This sent the Vix up 15.5%.
4. 'Hysterical Thursday’ on May
As described above, the Vix leapt 24.8%.
5. 'Greece Two’ on May
A divided response to the European Stabilisation
Mechanism sees the fear gauge rise 29.6%.
So that’s a second reason why implied
volatility may be behaving so strangely. It’s the
binary, risk-on or risk-off mentality that leads to
today’s fat tails.
Theory 3: Policy
Policymakers always exert an influence on markets, but in
the past two years this has been exceptional – and
with exceptional results.
In recent months, the 10 year dollar swap spread has dipped
into negative territory for the first time – a sign
that US government risk is actually seen as worse than that of
banks. The credit spreads over Treasuries of several blue chip
corporate bonds have also turned negative.
While some of this is technical noise, government stimulus
– with the huge increases in national debt that it
entails – must have played a part.
The last 18 months have produced the $700bn Tarp, the
£200bn Bank of England Asset Purchase Facility and the
€440bn European Stabilisation Mechanism. This is to say
nothing of central banks’ near-zero interest rates
around the world.
These sentiment-soothing bailouts have done just what they
were supposed to do – calm markets, quickly. No wonder
the Vix is more variable than ever.
Which way to jump?
I could go on with the theories... But regardless of the
reason for this fat-tailed volatility environment, what really
matters is what we do about it.
It’s very hard to say. But it is apparent that
both sides of the coin are fraught with risk for options
Conventional wisdom says that when volatility is
'cheap’, meaning low, a rational investor should
However, as we have discussed, it is very hard to know
whether to buy calls or puts. Momentum trades are non-existent
right now because the stockmarket itself has no momentum. When
stocks keep flying up and thumping down again, how do you take
Conversely, when volatility is 'rich’, ie.
high, the standard investment is to sell options, whether calls
or puts, to reap the high premiums.
When volatility is extremely high, an investor can write
options further out of the money for the same pay-off.
The problem here is the generic risk of option-writing
– assignment. That is, the risk that the strike price
gets struck. The investor would then take a loss, or be unable
to participate in the momentum of the underlying asset. And,
when the array of outcomes is so varied, the risk of assignment
nullifies the efficacy of writing options, even those that are
Of course, high volatility, high premiums and high risk of
assignment usually go together. But what the options writer is
looking for is moments when implied vol and the options price
are higher than is justified by recent history – the
historical or realised volatility. In other words, for
volatility arbitrage opportunities.
In recent months, this has been hard to achieve, as realised
volatility has had plenty of bite, rising just as fiercely as
what is implied.
So what’s an investor to do?
Invest from the bottom up, not the top down. Even at times
of excess kurtosis – wild, marginal behaviour in the
markets – there will always be individual deep value
If the rogue call options demonstrate anything,
it’s that it’s possible to find
compelling value, irrespective of the macro headwinds.
Failing that, at least there’s a good excuse
for trading losses – it really is rough out there!
Theo Casey is editor of The Fleet Street
Letter and a columnist for MoneyWeek.