As a firm believer in the advantages in volatility timing for one's market timing strategies rather than simply traditional surface area of price market timing, I analyze a decent amount of data in the derivatives space. More specifically, the futures and options markets. I focus on ES contracts, which are essentially futures contracts that track the S&P 500 index, but are quoted in smaller notional values than traditional futures contracts on the S&P 500 index, which allows for more liquidity (more people are able to play with more contracts since it is more affordable) and better price discovery (with more market participants on this product, there is inherently more information conveyed, so the chances of arbitrage strategies as a result of an inefficient pricing of the given product is much less likely than the traditional futures contracts). In order to get a sense of what volatility might look like in the future (implied volatility), I analyze options on those ES contracts, as options are essentially volatility products. Market makers and traders price these contracts in terms of their respective implied volatility values. The higher the implied volatility values, the more expensive the option is. So, before I go into a deep-dive implied volatility discussion, we first have to ask ourselves the question of what the heck is a skew?
The Skew
An implied volatility skew can be described as follows: there are two types of implied volatility skews, strike skew and time skew. Strike skew involves how options that are further in-the-money (ITM), with a constant maturity date, are quoted with higher implied volatility values, and the more out-of-the-money options are quoted with higher implied volatility values. If you graph this out, it might look like a "smile", with the at-the-money implied volatility value being the smallest relative to the other values. For the time skew. an option with a constant strike price, yet differing expiration dates, will have (in theory) rising implied volatility values the further out in expiration you go. These can be called IV smiles, smirks, and skews. Now that we know what skew means, let's move on to the bulk of our discussion in regards to how to use this new piece of critical information.
Supply and Demand Dynamics
I would first like to comment on the supply and demand mechanics of options markets. If participants want to buy options, since they are essentially forward-looking volatility products, you are buying volatility. So, if a bunch of people buy a lot of calls on a particular stock, then the dealer will raise the implied volatility values of those options, as they are now more expensive relative to their past prices due to increased demand. With this in mind, I will first bring data on the most active strikes of options on the ES contracts.
This chart shows the amounts of open interest of options on various ES futures contracts. Open interest means the number of outstanding open contracts on the given strike price (but in this case, it just means the amount of open option contracts on the ESH1 futures contract). This contract has about 36 days until expiration. What one should take away from this graph would be how there is much more orange than yellow. This represents how there is much more open interest on put options than call options (576,904 vs 306,971, respectively). Oh, and by the way, about 99% of those open put contracts are out-of-the-money, versus only about 55% of calls being OTM contracts. This tells a couple things: first, that demand for downside protection is much more heavily weighted than upside demand captures. More people are paying a premium in betting that the underlying index, the S&P 500, will decline in value. Second, that total volume on all ES put versus call options contracts is much larger (278,178 vs 137,997, respectively), as well as total open interest on all ES contracts (2,107,691 vs 963,676, respectively). People are beginning to price in a decline in the SPX and are willing to pay a significant premium for it. With the SPX moving a marginal amount the past couple days, this presents a significant opportunity, as the SPX is essentially flat, while downside protection is rapidly increasing. This could mean that there is a mispricing in the spot level of the SPX index relative to the amount of bearish options activity that is occurring. Seems as if the SPX will play catch-up with the demand for downside protection. Another interesting data point is how CME (Chicago Mercantile Exchange) pointed out how the most active strike today (as of the close) was the 3250 put contract, symbol EW2G1, with a previous day volume of only 1,279 rising to a volume today of 25,253, an increase of about 1,974%. One can clearly see that there is significant demand for bearish directional contracts when the market is essentially at all-time-highs.
ES ATM Volatility
When trading options contracts that are quoted in implied volatility terms, it is important to note if the option is "cheap" or "expensive" relative to past history. For example, if a contract was quoted with 10% implied volatility, but now it is quoted with 20% implied volatility (ceterus paribus), the option has what is called an "implied volatility premium", and will therefore be more expensive. The following chart will display historical ATM implied volatility values.
This chart is important because it helps show how ATM implied volatility is being fundamentally mispriced. One can see that the historical implied volatility (blue line) is extremely cheap relative to its past values (on a one month time frame), deeming the ES_30 futures contract having "cheaper" option characteristics embedded upon it. In addition to the historical implied volatility discount, there is also a implied vs realized volatility discount. The 20 day historical volatility value is currently above the current ES_30 implied volatility values, suggesting there is a slight discount relative to realized volatility (which is, in my opinion, more important of a metric out of the two). So, not only are you getting a deal on options from a historical view of implied volatility pricing levels, but also for when it is relative to its realized volatility! One can now see why so many options contracts were bought today. I mean, who wouldn't want a good deal?
The Implied Volatility Skew
Here is where I reference "The Skew" in depth, as it is extremely important in predicting fundamental prices of markets. Due to the increased demand we saw for put contracts, they would furthermore be priced more expensively than call options (basic supply and demand). An important note is how there is (usually) a skew aimed more at the put side. This is because, ever since 9/11, there has been a fundamental shift in a risk aversion sense, as portfolios across all asset classes contain some level of insurance against a black swan event. To illustrate this point, I will bring into question a chart showing the ES Risk Reversal Volatility levels.
This chart depicts what would be called a "risk reversal" trade. A risk reversal is essentially a sort of hedge on a directional trade for a given security that contains some derivative component to it (most often options contracts). It is essentially using call and put options to protect your core directional position on the underlying. For example, say you were short/long a stock, and you wanted to put on a hedge in case of any adverse black swan event occurring. To long/short a risk reversal, one would buy/sell a call option and sell/buy a put option (respectively). If you were originally short the underlying, and the stock happens to move upwards after you put this hedge on, your short put option position would increase in value, as well as your long call position, further offsetting your potential loss. Ideally, one would short OTM options contracts (usually something with an absolute value delta of 25) in order to receive a debit for that option premium to help offset the total cost of the trade.
After that explanation, it is time to interpret what this graph is showing. The top two lines are risk reversal values for 1 month of history on the ES_14 and ES_20 contract, with the orange being the ES_20 and blue being the ES_14 contracts. The important thing here is how the graph is within the negative numbers section. This effectively means that put options are more expensive than call options (so downside protection, for traders long the currency, is relatively expensive). To get further specific, further examination of the graph notes how put and call option volatility values are 19.39 and 13.43, respectively, further reiterating the negative risk reversal value of -5.95. However, I can understand that put options being more expensive relative to call options can be perceived as bad, but this is an incorrect mentality. If you recall in my previous posts, dealers have built a heavy net short position in futures contracts over the past few months, essentially meaning that they are selling futures contracts more than they are buying them. With this bearish skew in futures activity, it can be reasonable to understand how there would be a much steeper skew for downside protection, as market makers now have provided demand for these very products (remember, more demand means more implied volatility, hence the higher values). Oh, and one more quick thing about this graph. Notice how the orange line is below the blue line? This means that put options on the ES_30 futures contract (ES contracts expiring in about 30 days) are more expensive, on a relative basis, compared to the put options on the ES_14 contracts. So, if one were looking for a more cost effective way to enable a risk reversal trade on the S&P 500 index using futures options, it would be wise to consider the relative pricing of this trade (if you were short a risk reversal, then the opposite would be true, as you would then want the more negative risk reversal value).
Just to reiterate this concept of put options being more expensive than call options (on a relative basis), let us now examine a graphical representation on the ES_30 call and put skew values.
As one can clearly see, the call (bottom) and put skew values seem to be inversely correlated, which can be reasonably expected since they are instruments that initiate the opposite directional volatility trade. The graph is a little blurry, and I apologize for that, not sure why that happened, so allow me to explain what is happening here. However, I need to first explain what delta is. In options theory, delta is the amount the call price moves per one point move in the underlying asset. For example, if you own a call option on a stock with a delta value of 50, and the stock moves up one point, then your option should increase in value by 50 cents. The further out-the-money an option is, the smaller its delta value. So, the graph examines skew values on 15 delta and 25 delta call and put options and their historical skews on a one month time frame. So, on the call option chart, the fact that the 15 delta call has a call skew value of -3.95% and a 25 delta call has a call skew value of -2.85% makes sense. The farther out option has a steeper skew value than the closer to the money call option, which is inline with our previous discussion on defining the implied volatility smile. These negative values essentially mean that these 15 and 25 delta calls have an implied volatility discount, relative to the at the money option implied volatility, of -3.95% and -2.85%, respectively. Now, this is completely opposite for the analysis of put skew data, with the 15 and 25 delta put options on the ES_30 futures contract being +9.39% and +4.54%, respectively. Clearly put options are being priced on a more expensive basis than call options, which is clearly consistent with academic literature explaining why this relationship exists. However, the real reason why I wanted to bring these graphs into question would be how these skew values for call and put options are highest and lowest values, respectively on a 1 month time series. Yes, the absolute values of the put option pricing dynamics may seem scary, but they are the cheapest they have been in a month on a relative skew basis, and calls are the most expensive they have been in a month! See below graph for a good visual on this topic to help reiterate the same point.
Positioning for Relative Value
So, if you have read to this point, props to you, as this part might be the most important piece. This section will be dedicated to, if you were to solicit a hedge for future volatility, which futures contract might be more cheap compared to other similar futures contract.
This chart shows the at-the-money distribution of implied volatility on several futures contracts, and several respective average ATM implied volatility values throughout a range on contracts. What you would take away from this chart is how much further away the E1AH21 futures contract is away from a historical average across multiple other futures contracts. This means that this future's ATM implied volatility value is lower, on a relative one month basis, than the rest of its counterparties (futures contracts that have 7, 14, and 30 days left until expiration, and the DTE's in between those three values). So, if one were to put on a trade to hedge for the downside (NOT placing a short risk reversal trade, simply buying an ATM put contract on an ES contract), the E1AH21 futures contract would be the cheapest to do so from an option pricing perspective.
Conclusion
In summary, there has been increased demand for downside protection in the ES futures contract market which could potentially be a bearish indicator for future returns on the S&P 500 index. Furthermore, pricing mechanics on both the call and put side show favorable conditions to put on downside protection as a hedge. Now, without further ado, let's get this bread.
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