In this Wide World of Options episode, host Mark Benzaquen welcomes Ed Tom, Senior Director – Cboe, to discuss volatility indices and products.
TRANSCRIPT
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Now here’s your host, Mark Benzoquin.
Hello everyone and welcome to OIC’s Wide World of Options.
I’m your host, Mark Benzoquin.
For November, OIC has a pair of webinars lined up discussing volatility products, namely volatility indices, futures and ETFs.
And to help highlight our upcoming presentations, I’m happy to welcome Ed Tom of CBOE’s Market Intelligence team.
Ed, welcome and thanks for joining us today.
Thanks Mark.
Ed, to be fair, before we get started, why don’t you take a minute, tell us a little bit about yourself and your involvement or your experience in the world of options.
Sure.
So this is my 35th year in Wall Street.
I basically spent my entire career working with equity derivatives and quantitative strategies.
I started off at JP Morgan and then moved on to Salomon Brothers.
I spent 20 years at Credit Suisse where I was the global head of equity derivatives and quantitative trading strategies.
And the last eight years I spent at different hedge funds and most recently at Ellington where I was there for three years working on the downside equity convexity strategy.
Okay.
And now you’re with CBOE, Market Intelligence.
Tell me a little bit about that, please.
So basically that’s the derivatives research arm of CBOE where we basically provide market commentaries on volatility moves and different volatility strategies and products.
Okay, excellent.
Thanks.
I appreciate the background information.
Speaking of CBOE or CBOE as they’re now known, as a representative from one of the exchanges that offer various volatility products and seeing as how we’re going to be talking about volatility products in our November webinars, I was hoping that you could walk me and our audience around some of the concepts surrounding volatility products.
So let’s go ahead and start at the beginning and let’s assume that we’re talking to an investor that really has no idea about volatility products, what they are and how they work.
But they do know about options.
So when it comes to volatility products, it’s a little bit different, right?
There is no stock that we’re looking at.
How do volatility products work in that sense?
Can you be bullish or bearish on volatility?
Yeah, you can.
So basically like taking a step back, volatility is essentially a measure of the stability of the markets.
And in general, there’s an inverse relationship between the performance of the markets and volatility.
So if, let’s say, the markets rise, generally, volatility falls.
And if the markets start crashing, then volatility rises exponentially.
So basically, that’s a general relationship.
And that remains intact, I would say, about 85% of the time.
And there are products to basically take expressive views on volatility.
Yeah, there’s a saying that one of my colleagues likes to use that the market goes up on a staircase and down in an elevator.
Things crash.
The market goes down much quicker than it goes up.
So I understand that inverse relationship between volatility.
So with that in mind, what are volatility products?
Again, there isn’t a stock.
There is no XYZ volatility company out there.
So what are volatility products?
How do they measure?
How do they work?
Can you shed a little light on that?
Yeah.
So basically, I think to start off with, we need to first discuss the industry benchmark for volatility, which is the VIX.
So what the VIX is is basically a measure of three things.
It basically measures the volatility of the markets due to economic fundamentals.
It also layers on top of that the relative demand for puts versus calls on behalf of portfolio managers.
And finally, the third component is the additional premium that traders accord to a potential tail risk, a tail shock.
So in combination, that’s essentially what the VIX is.
All right.
And the VIX, while it isn’t the only volatility game in town, so to speak, as you had mentioned, it is an industry standard.
So talking about volatility without specifically talking about the VIX is kind of a hard thing to do.
So what does the VIX measure?
Or better yet, how does the VIX measure?
So there’s a value, right, that volatility index.
There’s a value each day.
It’s trading at X.
How is that X, A, calculated, and B, what is it telling investors?
So I think to understand the VIX, we first need to kind of like take a look at how options are priced.
So options are priced using five parameters from the Black-Scholes model.
And the one parameter that is not super transparent to most investors is volatility.
Right, not observable.
Everything else, stock price, strike price, interest rates, dividends, those are all observable, quantifiable, volatility, that’s the guesswork.
Exactly right.
So basically, how volatility comes about is we observe the current price of a particular option.
We plug in all the known parameters, including strike, tenure, et cetera, and then implied volatility is essentially the number that basically solves the Black-Scholes equation for that particular price.
So basically, what the VIX is, is a weighted average of implied volatilities across the entire S&P strike chain.
Okay, so it’s the average price or it’s the average volatility level across all 500 components of the S&P?
Well, so we’re looking at the S&P as a whole, and we’re looking at all the listed strikes for any particular maturity.
So the VIX will be very close to the average level of the implied volatility of the S&P for any particular expiry.
Okay.
Prior to the creation of the VIX and prior to the creation of other volatility products, how did traders gauge volatility?
Meaning that now that we have the volatility indices, it fulfills a certain need in the market.
What filled that need prior to the creation of these?
Or better yet, what was that need that led to the creation of these volatility products?
Yeah, so prior to the creation of VIX, traders used to refer to Realize Volatility, which is basically like the same calculation that one uses for calculating standard deviation.
But the problem with Realize Volatility is that it’s descriptive, meaning that it’s backward looking.
And there was a need for a measure that was a little bit more forward looking.
So that’s how the VIX came into being because implied volatility layers on some expectations or predictive components on top of Realize Volatility.
Okay.
All right.
I understand that.
Let me shift gears for a second.
And let’s look at some of the other indices, for example, the S&P.
Again, a benchmark index that people use.
There is no stock.
There is no S&P 500 stock.
How does, when it comes to a volatility index, how does that work?
There’s a futures contract as well, I assume.
Not I assume.
I know that there is a futures contract as well.
What does that futures contract– if I buy a futures contract in a commodity such as oil, I know that at the end of that term of the contract, I’m going to end up with, what, 5,000 barrels of oil in my backyard if I let that contract go through to expiration.
What do volatility futures, what is the end game, or how do those work?
So I’m glad you bring up oil futures because I think that’s a very good analogy.
So when we look at, let’s say, S&P futures, that’s a very simple type of future to understand because it’s known as a cash and carry instrument, meaning that if you buy the spot and then you basically invest that money into– sorry, you sell the S&P spot and then you invest that money into the bank, at some future point in time, you know exactly how much the value of that holding would be worth.
And that will be basically the price of the S&P future.
But with VIX futures, there are a couple of different other components that are added to the cost of the future based off the current price of VIX.
And a good portion of the premium that is accorded to VIX futures is based off of the expectation of traders of what volatility will look like at some future point in time.
And also the demand for volatility at that future point in time.
So basically, there’s a mathematical component and there’s also a supply and demand component that is accorded to VIX futures.
OK.
And when it comes to VIX futures, they’re a little bit different than a typical futures contract in the sense of back to S&P, for example, those are quarterly futures.
I think they’re listed in what, December, March, June, and September.
Those are the four quarterly futures for the S&P.
But with the VIX and other volatility products, I believe it’s different.
There’s monthly contracts.
So for example, what I find interesting is if you’re trading a time spread, a calendar.
If we had a March, April calendar or diagonal in a volatility product such as the VIX, we would have– the March option would be tied to a March future and the April option would be tied to an April future.
Do I understand that correctly?
That’s correct.
That’s right.
Yeah.
So how traders have been expressing, let’s say, the upcoming presidential elections.
They basically trade a calendar spread on either the October, November term structure or they trade the November, December calendar spread.
OK.
And that brings up a good point.
For a investor interested in trading a volatility product, are they mostly looking to capture differences in volatility, changing volatility?
Or might they just buy some calls on a volatility ETF or an index just as they would stock XYZ with the expectation that volatility is going to increase?
So for that average investor, is that kind of a way that they might take advantage of volatility and trade the VIX or trade a different volatility product?
Or are there maybe other reasons?
Are there other things that they’re hoping to accomplish?
Yeah.
So basically, I think that in general, your statement is correct.
But the tricky thing about trading VIX futures is that the benchmark isn’t the current level of VIX, but rather what traders have already priced into that future price of VIX.
So for example, right now, the current level of spot VIX is 17.
OK.
So one might think, OK, well, you know what?
I think that the November elections will cause an uptick in market volatility.
So I’m thinking to buy November X-free VIX options.
The problem is that at this point, volatility traders have already priced in an additional premium for November.
So the November futures contracts might be higher than 17.
So let’s just say that it’s 20.
So in order for an investor to actually profit from a view on November VIX contracts, the VIX futures need to rise above 20.
So basically, it needs to exceed the level that’s already being priced into the markets.
OK.
OK.
So are you saying that that’s kind of like maybe even a break-even point, that it needs to be above or below that point in order for the trader to profit?
Yeah.
So basically, if you plan to unwind prior to X-free, that is true.
Yes.
OK.
So if you hold to X-free, then the effect is a little different.
Then the thought is that, OK, well, then the benchmark really is spot VIX.
But for most investors, one tends to trade to basically monetize their gains pretty much immediately after the event.
OK.
Speaking of spot VIX, you had mentioned spot VIX.
You had mentioned it’s currently trading around 17 or so.
Do I have– well, let me ask you this.
Typically when I think of implied volatility, right, not a volatility product, but the concept of implied volatility we talked about earlier, if implied volatility is 17%, it’s telling us that according to how the market is pricing this particular option, they’re expecting a 17% move up or down in that underlying over the next 12 months.
That’s kind of an idea of implied volatility.
With the VIX trading 17, as you had mentioned, does that concept still kind of hold true?
Is it saying that the market is expecting a 17% swing as evidenced by that VIX number, or is it telling us something completely different?
Yeah, I think that that’s close enough.
But I think a better way for most investors to grasp the idea of a 17 VIX is basically to use something called the Rule of 16, which is basically a way to convert an annualized volatility number into a daily move.
The square root of trading days in the year, typically 252, comes out to roughly 16, hence for our listeners that are wondering what we’re talking about, hence the Rule of 16.
Yeah, exactly right.
So basically, the rule of thumb is that an annualized volatility level of 16 equates to about a 1% move per day.
I think for most investors, that’s an easier way to kind of translate the current level of VIX to a more understandable move.
Okay, understood.
Thank you.
So volatility indices, volatility futures, we’ve got ETFs on volatility.
These are all different products, but all really kind of try to accomplish the same thing, which is providing investors a vehicle in which to hopefully profit on whatever their forecast may be.
And one of the interesting things, again, getting back to implied volatility is that because it’s not quantifiable, it’s not observable, as you had mentioned, that is a point of contention amongst investors.
If you think volatility is 20%, and I think it’s 25, we each have our different models, whether they’re proprietary algorithms that we run or what have you, whatever our pricing models tell us, if you think it’s 15, I think it’s 20, or you think it’s 20, I think it’s 25, the difference in volatility, the difference of our opinion is going to be reflected in what we think of the fair value of that option contract.
Now the volatility products, again, back to the VIX, for example, does that work similar to where, well, the VIX is trading 17, I think it should be much higher, or I think it should be much lower.
So because of that, it’s going to affect my pricing models, and therefore it’s going to maybe form a strategy, a trading strategy where I’m buying or selling.
Are there those differences of opinions in the VIX as well, or vol futures, vol ETFs, does it kind of work that same way, where you think one thing, I think something else, and therefore we’ve got to trade, or am I completely off the mark on this?
It totally does.
So basically, I think that for most investors, it’s easier to kind of express a view on where the S&P is going to be at some point in the future.
And whatever that level is, there’s a certain market for the probability that the S&P goes to that particular level.
That level, basically the probability is impounded into the implied volatility with that particular strike.
And if you were to basically visualize all those implied volities by strike, we would form what’s called the S&P implied volatility skew.
And all the differences in opinions basically changes the implied volatility skew, which again, taking a step back, is basically the differences of demand for different puts versus different calls along the S&P strike chain.
So the skew can rise and fall depending upon traders’ views of the likelihood of a downside shock or an upside rally in the S&P.
And basically, the way that the skew kind of behaves will be an aggregation of all those different opinions amongst volatility traders.
Excellent.
Okay.
Well, thank you.
That makes sense.
Ed, excellent information.
I really appreciate it.
Thank you for sharing that with us.
And thanks for agreeing to guest on the show.
Much appreciated your time.
Thank you.
Okay, great.
Thanks, Mark.
And folks, that’s going to do it for today’s episode of Wide World of Options.
Special thanks to our guest, Ed Tom from CBOE, and taking the time to sit with us and talk options and for his insight into the world of various volatility products.
Please join us next time when we’re going to be back with a whole new show, featuring more industry names, market concepts, and of course, trusted options education.
In the meantime, be sure to visit the events section of our optionseducation.org website to register for our upcoming webinar events and feel free to explore the rest of what OIC has to offer while you’re there.
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And as always, please feel free to send us your questions via email at options@theocc.com or you can live chat with us on our website.
Take care, everyone, and we’ll be talking with you again very soon.
Thank you, Bob.
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