Ever wonder how markets price for events like the global financial crisis of 2008 or this year’s COVID-19 pandemic, which we are told are “unprecedented”?
The answer is that the best they can do is look at the past and decide which scenario looks most like the present. That is why the history of financial markets tends to rhyme. It’s no different in option markets—in fact, the rhyming is often particularly strong here because, unlike the level of securities’ prices, the volatility of securities’ prices is generally indifferent to its cause.
History Rhymed
For example, let’s look at how the futures curve for the CBOE S&P 500 Volatility Index (VIX) was priced on March 16, 2020, the day the spot price for VIX set a record high of just over 82.
Figure 1 shows the market’s expectations for VIX pricing seven months into the future from that date. It also shows the VIX futures curve as it stood on November 20, 2008, when the VIX spot hit its highest level of the global financial crisis, as well as the prices at which the VIX futures that were listed in November 2008 actually settled over the five months to June 2009. The vertical line at three months represents where we are today.
Figure 1. COVID-19: Like 2008… But Also Not Like 2008
The VIX futures curve on March 16, 2020 and November 20, 2008, plus realized VIX spot prices between February and June 2009
Source: Bloomberg. Data as of June 10, 2020. For illustrative purposes only.
What we see strongly suggests that, with little to no idea what was about to transpire on March 16, 2020, the futures market essentially priced the near-dated part of the VIX futures curve consistent with the way it priced in November 2008, at around 60 – 80.
That makes sense. The market could only guess at what the impact of a pandemic would be, but it was a fair bet that it would be rather large. And when was the last time that uncertainty and fear were this severe? The 2008 global financial crisis.
But compare the later-dated parts of the futures curve for March this year and November 2008. The March 16 curve was lower—more like 30 at month seven rather than 45. In other words, while the market expected spring 2020 to be as volatile as winter 2008, it was expecting that volatility to calm down much more quickly than it had been when it was pricing future volatility in November 2008. In fact, it priced for a calming effect that looks very similar to what actually transpired in the aftermath of the financial crisis.
Maybe the market didn’t believe that the COVID-19 crisis would lead to a systemic breakdown of finance, as 2008 threatened to. Maybe it accounted for supportive fiscal and monetary policies that were already in place or quickly being readied. Or maybe it just “learned” from 2008 – 09, and priced accordingly. Whatever the market was thinking on March 16, history rhymed.
Bread-and-Butter Income
It would be easy to look at figure 1 and conclude that the great opportunity to ride the convergence of implied and realized volatility between November 2008 and June 2009, by writing put options, does not exist today. It looks as though the opportunity to make money passed in a flash.
But let’s take a step back. Just because the VIX futures curve is not as high as it was back in November 2008, that doesn’t mean that it isn’t still high relative to most environments—it’s amazing how quickly our definition of what’s normal can change.
Figure 2 plots the evolution of the VIX spot price since the high of March 16, and the current VIX futures curve, against the aftermath of six other high points for the VIX from history. What we see is that the market expects volatility not only to remain substantially higher than the long-term average, but also high relative to most of these other high-volatility events from the past.
Figure 2. The 2020 Volatility Vintage Is Aging Well
The VIX Index in 2020 and its forward curve into 2021, versus six historical high points and its long-term average
Source: Bloomberg. Data as of June 10, 2020. For illustrative purposes only.
For those looking for quick, outsized, leveraged profits from trading volatility, the opportunity was indeed fleeting. But for those of us who are focused on capturing premiums over time, while short-term spikes in implied volatility, such as the one in mid-March and the 48% jump in the VIX on June 11, are helpful in pushing the medium-term average level up, it’s the average levels rather than the spikes that are more important.
That’s the source of bread-and-butter income, rather than sugar rushes—and so far, we believe 2020 looks set to provide plenty of sustenance.
Aftermath
What’s remarkable is that we are talking about the market pricing in future S&P 500 volatility on a par with what we saw realized after the financial crisis of 2008. This is happening even though the S&P 500 got back within 5% of its peak value just 74 days after it troughed on March 23. It took the S&P 500 three and a half years to achieve the same feat after hitting its 2009 financial-crisis trough.
We can see this from another angle in figure 3, which plots the current VIX futures curve (85 days after the S&P 500 trough of March 23, 2020) against the VIX futures curve as it stood on June 2, 2009 (85 days after the S&P 500 trough during the global financial crisis). We also reproduce the curve as it stood on March 16 this year.
Again, we can see that short-dated implied volatility has declined substantially from its high levels in mid-March, but longer-dated implied volatility remains at similar levels to what we had in the aftermath of 2008—despite the extraordinary, v-shaped recovery we have already seen in the underlying S&P 500 Index itself.
Figure 3. Despite a V-Shaped Equity Recovery, Implied Volatility Remains at 2008 - 09 Levels
The VIX futures curve 85 days after March 16, 2020 and 85 days after November 20, 2008, plus the curve on March 16, 2020
Source: Bloomberg. Data as of June 10, 2020. For illustrative purposes only.
What Is Going to Happen This Year?
Higher average VIX means higher returns for strategies that sell put options, right? Well, perhaps. It certainly means that more cash flow is collected. But we would argue that selling puts is a more efficient way to collect the equity and equity-volatility risk premiums, and therefore the real question is whether higher average VIX makes it more likely that selling S&P 500 puts will outperform the S&P 500 Index itself.
The data in figure 4 suggests an answer, based on history since 1986. When S&P 500 returns amounted to less than 10% over 12 months, the CBOE S&P 500 PutWrite Index (PUT), which replicates a systematic collateralized put-writing strategy, was likely to outperform the S&P 500 regardless of whether the VIX had been above or below its long-term average level of 20. If the S&P 500 lost money and the VIX was higher than average, it was virtually a slam dunk. If the S&P 500 return was between zero and 10%, the probability of outperforming by selling puts remained strong in higher- and lower-volatility environments.
Unsurprisingly, the likelihood that selling puts outperformed was lowest when 12-month returns to the equity index were strongest, at 10% or more. Even so, when this coincided with a higher-than-average VIX level, that likelihood more than doubled to a respectable 35.8%.
Figure 4. Probabilities of the PUT Index Outperforming the S&P 500 Over 12 Months, June 1986 to Present
Source: Bloomberg, Neuberger Berman. Implied volatility estimated using the average daily level of the CBOE S&P 100 Volatility Index (VIX) which has daily data available from January 2, 1986. The CBOE S&P 500 PutWrite Index (PUT) incepted in June 2007 with historical back-tested data available from June 30, 1986. For illustrative purposes only.
What is going to happen this year? There’s no way of knowing, especially given the current uncertainty. But we can look at what the market is pricing in. S&P 500 futures for settlement in December 2020 currently imply that the Index will end the year down by around 6%.
That’s remarkable, given it was down more than 30% just three months ago. But, as we’ve seen already, what’s even more remarkable is that the VIX is expected still to be up around the 30-plus level by the end of the year—despite the recent huge, rapid and almost uninterrupted rally for the S&P 500.
Can the S&P 500 put in a further 16% from here, to end the year up 10%? It’s possible, of course. But the evidence we present here, of the VIX rhyming with history despite the unprecedented v-shaped path of its underlying equity index, explains why we continue to see growing interest in option writing strategies.