Interpreting Volatility-Related Indicators & Benchmarks William Speth, Head of Research Cboe Multi-Asset Solutions Team March 7, 18
Volatility-related indicators & benchmarks unlock valuable information in options prices Options reflect expected risk in the future, and the market price of protecting against that risk. The Cboe Volatility Index (VIX ) combines prices of hundreds of SPX SM options to provide a single, standardized benchmark for -day expected volatility of S&P 500. Other volatility-related indicators and benchmarks provide a more nuanced and complete view of expected risk: Volatility of Volatility Cboe VVIX Index Skew Cboe SKEW Index, 90%-110% IV & CS Fear Barometer Term Structure VIX, VVIX & SKEW Correlation Cboe S&P 500 Implied Correlation Indices (ICJ, JCJ, KCJ) Can be tradable or generate trading signals 2
The VIX Index
What is the VIX Index? The VIX Index is an up-to-the-minute market estimate of -day expected volatility of the S&P 500 Index that is calculated by using the midpoint of real-time SPX option bid/ask quotes. The VIX Index methodology isolates pure volatility exposure directly from option prices. The VIX Index was designed as an underlying for tradable products. The VIX Index reflects what investors are actually paying for protection rather than how they are feeling about risks generally. VIX vs. SPX Long term negative correlation with SPX returns (-.70); with short term variability VIX Index moves are convex to SPX; some of the largest VIX % moves have taken place during low volatility 80% 60% 40% % VIX Return The VIX Index tends to spike in response to sharp down moves; falls more slowly in rising markets SPX Return 0% -15% -10% -5% 0% 5% 10% 15% Source: Cboe -% -40% 4
Other things you should know about the VIX Index The portfolio of SPX options comprising the VIX Index changes every minute The range of strikes used in the VIX calculation is dynamic and is determined by the zero-bid rule As implied volatility increases, more OTM puts / calls become bid and the strike range increases As implied volatility falls, more OTM puts / calls have no bids and the strike range decreases. Implied SPX Price Distribution 50 Vol 25 Vol The VIX Index rises when option premiums increase and/or SPX strike range is extended 1.6 1.5 VIX / SPX ATM IV 1.4 1.3 1.2 1.1 1 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15 Jan-17 5 Source: Cboe, Bloomberg
VIX of VIX (VVIX)
Beta What is VIX of VIX? The Cboe VVIX Index ( VVIX ) measures the volatility of the -day forward price of the VIX Index. This forward price is the price of a hypothetical VIX futures contract that expires in days. VVIX is calculated using the VIX methodology applied to near- and nextterm VIX options. VVIX is not the same as the expected volatility of the spot VIX Index, but the two are related. Source: Cboe Beta of -day forward VIX to spot VIX 0.50 Since 07, average VVIX value is 88 vs. spot VIX volatility of 128 1.00 0.90 0.80 0.70 0.60 0.50 0.40 0. 0. 0.10 0.00 Beta of VIX Futures to the VIX Index R² = 0.9219 0 21 42 63 84 105 126 147 168 189 210 231 252 VIX Futures Days to Expiration 7
VVIX VIX Properties & Uses of VVIX VVIX and VIX returns are positively correlated 0.80 Highest 10% of VVIX values associated with Avg. VIX Index value of 28; 6 of highest VVIX values occurred in February 18 (record 180 on 2/8) VVIX can be used to estimate risk premium of VIX options; expected variability of VIX Index values; an input to determine VIX futures FV 140% 1% 100% 80% 60% VVIX % R² = 0.6405 140 1 100 80 60 Avg. VVIX Avg. VIX 25 40% % VIX % 0% -40% -% 0% -% % 40% 60% 80% 40 0 1 2 3 4 5 6 7 8 9 10 15 10 Source: Cboe -40% VVIX Decile 8
VVIX VIX Recent VVIX behavior suggests demand for VIX options is another way to measure expected risk VVIX has tended to be more correlated to the VIX Index since 10 Notable divergence in Q3/Q4 17 190 170 VVIX VIX 90 80 70 150 60 1 50 110 40 90 70 10 50 07 08 09 10 11 12 13 14 15 16 17 18 January 07 through February 18 Source: Cboe 0 9
Skew Indicators
50 60 70 80 90 100 110 1 1 60 70 80 90 100 110 1 1 140 70 80 90 100 110 1 1 140 150 What is Skew? The difference between an observed price distribution and a theoretical normal distribution, whether large moves are more likely on the downside or upside. Option prices generally reflect the price of expected risk; OTM option prices reflect tail risk 28 26 24 22 18 28 26 24 22 18 28 26 24 22 18 Strike Strike Strike 11
Measuring Skew with Options Cboe S&P 500 Skew Index (SKEW SM ) - derives expected skewness ( tail risk ) of the S&P 500 using a strike-independent portfolio of SPX options Like the VIX Index, uses -day options and range of strikes can vary Statistic converted to index: SKEW = 100 10 * price of skewness Strike Skew compares the relative volatilities of OTM puts and calls equally spaced around ATM strike price (e.g., 90%-110% ) Most common reference for skew Flexible & intuitive CS Fear Barometer ( CSFB ) measures amount of downside put protection that can be purchased with the sale of a 10% OTM call Standardized pricing of a 3M zero-cost collar High level of CSFB means that investors are willing to sacrifice upside in order to buy downside protection 12
SKEW SPX SKEW Index measures expected tail risk of SPX SKEW methodology reflects imbalance of downside/upside tail risk SKEW Index has been increasing since 08 Possible structural, regulatory explanations 160 150 Cboe SKEW Index & S&P 500 00 2500 140 00 1 1 1500 110 1000 100 07 08 09 10 11 12 13 14 15 16 17 18 January 07 through February 18 Source: Cboe 500 13
What the SKEW Index is saying about perceived tail risk 140 135 1 125 1 115 110 105 SKEW Index measures the market expectation of a tail risk event Supply of out-of-the-money ( OTM ) puts limited by high cost of capital and risk management practices Few customers can sell uncovered OTM puts Liquidity providers demand more edge Average SKEW & VIX Index Levels Annually SKEW VIX 135 11.09 129 35 25 16.35 15 10 SKEW 2 SD Move Prob. 3 SD Move Prob. 100 2.% 0.15% 105 3.65% 0.45% 110 5.00% 0.74% 115 6.35% 1.04% 1 7.70% 1.33% 125 9.05% 1.63% 1 10.40% 1.92% 135 11.75% 2.22% 140 13.10% 2.51% 145 14.45% 2.81% 150 15.70% 3.10% 155 17.05% 3.40% 100 5 1990 1993 1996 1999 02 05 08 11 14 17 January 1990 through February 18 Source: Cboe 14
VIX / SPX ATM IV VIX / SPX ATM IV SKEW Is SKEW Tradable? VIX Index is calculated using prices of OTM SPX puts and calls, which reflect the expected left-leaning skewness of the S&P 500 Index Expect VIX values to reflect a premium over SPX ATM implied volatility; premium should correlate with SKEW, and suggests a way to trade SKEW 1.6 1.5 SKEW VIX / 1M ATM Imp. Vol. 1.4 1.3 1.2 1.1 1 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 160 150 140 1 1 110 100 1.5 1.4 R² = 0.5707 1.3 1.2 1.1 SKEW 1.0 100 110 1 1 140 150 160 Source: Cboe, Bloomberg January 06 through February 18 15
90% - 110% IV 90% - 110% IV is most common Skew reference point Variability of 90%-110% 3M IV less than 90%-110% 1M IV Delta skew [(25 delta put IV 25 delta call IV) / 50 delta IV] is a variation of strike skew that adjusts for volatility 25 90%-110% 1M IV 90%-110% 3M IV 15 10 5 Source: Bloomberg 0 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 16
CSFB 90%-110% 3M CS Fear Barometer offers unique & intuitive measure of market risk 50 45 40 CSFB 90%-110% (3M) 18 16 1.4 1.2 1 0.8 0.6 CSFB v. VIX 35 25 14 12 10 8 0.4 R² = 0.0763 0.2 0-0.4-0.2-0.2 0 0.2 0.4 0.6-0.4 15 10 6 4 0.8 0.6 CSFB v. 90%-110% 5 0 2 0 0.4 0.2 R² = 0.0511 0-0.4-0.2-0.2 0 0.2 0.4 0.6-0.4 January 07 through February 18 Source: Bloomberg -0.6 17
VIX CSFB VIX 90% - 110% IV VIX SKEW Skew measures didn t pick up downside risk 38 VIX SKEW 160 28 140 18 1 8 38 28 VIX 90%-110% 100 18 10 8 38 VIX CSFB 0 50 28 40 18 8 Source: Cboe, Bloomberg January 17 through February 18 18
SPX Implied Volatility due to demand for OTM calls relative to ATM Smirk became more of a smile Q3/Q4 17, January 18 as market moved to record highs; call selling slowed, short covering Demand for OTM SPX calls while ATM IV continued to grind lower Skew indicators interpreted the inversion of ATM and OTM call IV as more balanced risk, lower skew 35 25 SPX Option Implied Volatility by Moneyness 15 10 5 Source: Cboe, Bloomberg 0 1/4/16 4/4/16 7/4/16 10/4/16 1/4/17 4/4/17 7/4/17 10/4/17 1/4/18 90% 100% 110% January 16 through January 26, 18 19
VIX, VVIX & SKEW Term Structure
VIX, VIX Futures Price What causes the VIX term structure behavior? Mean reversion and longterm uncertainty drives VIX futures term structure. When VIX spikes, shorter dated futures are more responsive because less time for VIX Index to mean revert. Longer dated VIX futures less responsive because high levels of VIX Index historically unsustainable. 33 28 23 18 13 8 VIX Futures Term Structure during 18 Correction Backwardation: downward-sloping term structure Contango: upward-sloping term structure VIX UX1 UX2 UX3 UX4 UX5 UX6 UX7 UX8 UX9 26-Jan-18 9-Feb-18 Backwardation Contango Flat Apr-04 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11 Apr-12 Apr-13 Apr-14 Apr-15 Apr-16 Apr-17 Source: Cboe 21
VIX Futures Term Structure usually in contango but can be flat or in backwardation VIX Futures Term Structure January 16, 18 through February 15, 18 10-15 15- -25 25- -35 35 25 Source: Cboe 2/13/18 2/7/18 15 2/1/18 1/26/18 10 1/22/18 UXI UX3 UX5 UX7 UX9 1/16/18 22
VVIX Term Structure in backwardation, important implication for VIX options traders VVIX Term Structure January 2, 18 through January 31, 18 50-80 80-110 110-140 140-170 170-0 0 170 Source: Cboe 140 1/31/18 110 1/25/18 80 1/19/18 1/12/18 50 1/8/18 VV1 VV3 VV5 VV7 VV9 1/2/18 23
SKEW Term Structure generally upward-sloping but still reflects market shocks SKEW Term Structure January 16, 18 through February 15, 18 110-1 1-1 1-140 140-150 150 140 Source: Cboe 1 1 1/26/18 110 SK1 SK3 SK5 SK7 SK9 SK11 1/22/18 1/16/18 2/1/18 2/13/18 2/7/18 24
Cboe Implied Correlation Indices
What are ICJ, JCJ & KCJ? The Cboe S&P 500 Implied Correlation Indexes (ICJ, KCJ, JCJ) measure changes in the relative premium between index options and singlestock options. Index volatility is driven by a combination of two factors: the volatilities of index components and the correlation of index component price returns. ICJ, JCJ & KCJ are rotating tranches of implied correlation, each running for overlapping 2-year periods. Two tranches are active at any one time ICJ, JCJ & KCJ measure average implied correlation using SPX options and a tracking basket of the top 50 SPX components by market cap. Option implied volatilities are based on ATM strangles for both SPX options and options on stocks in the tracking basket. SPX tracking basket is re-balanced once per month 26
ICJ, JCJ, KCJ VIX ICJ, KCJ, JCJ VIX Correlation key driver of volatility - Tale of Two Correlation Regimes Implied correlation ranged from 50 70 through 15; began to decline in 16, along with the VIX Index After the 16 election, ICJ, JCJ & KCJ fell to historic lows, averaging 43. JCJ 18 fell below in October, as 1M realized correlation fell below 10. 80 70 60 50 40 10 0 Nov-13 Mar-14 Jul-14 Nov-14 Mar-15 Jul-15 Nov-15 Mar-16 Jul-16 80 70 60 50 40 10 (KCJ) JANUARY 15 (ICJ) JANUARY 16 (JCJ) JANUARY 17 VIX 0 Nov-16 Feb-17 May-17 Aug-17 Nov-17 Feb-18 60 50 40 10 0 60 50 40 10 0 (KCJ) JANUARY 18 (ICJ) JANUARY 19 (JCJ) JANUARY VIX Source: Cboe 27
Disclaimer Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies are available from your broker or from The Options Clearing Corporation at www.theocc.com. Futures trading is not suitable for all investors, and involves the risk of loss. The risk of loss in futures can be substantial. You should, therefore, carefully consider whether such trading is suitable for you in light of your circumstances and financial resources. For additional information regarding futures trading risks, see the Risk Disclosure Statement set forth in CFTC Regulation 1.55(b). The information in these materials are provided for general education and information purposes only. No statement within these materials should be construed as a recommendation to buy or sell a security or to provide investment advice. Supporting documentation for any claims, comparisons, statistics or other technical data in these materials is available by contacting Cboe at www.cboe.com/contact. The Cboe Volatility Index, Cboe VVIX Index, Cboe S&P 500 Skew Index and the Cboe S&P 500 Implied Correlation Indexes (the Indexes ) are designed to represent proposed hypothetical options strategies. The actual performance of investment vehicles such as mutual funds or managed accounts can have significant differences from the performance of the Indexes. Investors attempting to replicate the Indexes should discuss with their advisors possible timing and liquidity issues. Like many passive benchmarks, the Indexes do not take into account significant factors such as transaction costs and taxes. Transaction costs and taxes for strategies such as the Indexes could be significantly higher than transaction costs for a passive strategy of buying-and-holding stocks. Investors should consult their tax advisor as to how taxes affect the outcome of contemplated options transactions. Past performance does not guarantee future results. These materials contain index performance data based on back-testing, i.e., calculations of how the index might have performed prior to launch. Back-tested performance information is purely hypothetical and is provided in these materials solely for informational purposes. Back-tested performance does not represent actual performance and should not be interpreted as an indication of actual performance. Index performance returns do not reflect management fees, transactions costs or expenses. No representation is being made that any investment will or is likely to achieve a performance record similar to that shown. Parameters relating to past performance of strategies discussed are not capable of being duplicated. It is not possible to invest directly in an index. CBOE, CBOE Volatility Index, and VIX are registered trademarks and SKEWSM, SPXSM and VVIXSM are service marks of Cboe Exchange, Inc. S&P 500 is a registered trademark of Standard & Poor s Financial Services, LLC and is licensed for use by Cboe Exchange, Inc. Financial products based on S&P indices are not sponsored, endorsed, sold or promoted by Standard & Poor s, and Standard & Poor s nor Cboe make any representation regarding the advisability of investing in such products. All other trademarks and service marks are the property of their respective owners. 18 Cboe Exchange, Inc. All Rights Reserved. 28
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