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Insights
August 2020 Market Perspective
Wednesday, September 9, 2020
August was a fascinating month for volatility statistics. The most
surprising stat was that, after July’s record for the widest-ever positive
spread between average implied volatility and realized volatility, the spread
in August was even wider. The Cboe® Volatility Index (the VIX®)
averaged 22.89 in August, lower than July’s average of 26.84, but realized
volatility, as measured by the annualized standard deviation of daily returns
for the S&P 500® Index, collapsed from 13.28% in July to just 8.10%
in August. The plunge in realized volatility caused the spread between the two
statistics to increase from 13.56 percentage points in July to a new positive monthly
differential of 14.79 percentage points in August.
Nearly as surprising as the differential between implied and realized
volatility was the upward trend in implied volatility over the last half of
August. The VIX® had been in a steady downtrend as the equity market
recovered from its March 2020 lows. However, as the S&P 500®
Index reached a new all-time closing high on August 18 and continued to advance
over the remainder of the month, the VIX® changed course and trended
higher in concert with the equity market. The August closing low for the VIX®
was 21.35 on August 17. A new all-time high for the S&P 500®
Index was set the next day. From that point on, the S&P 500®
Index advanced 3.33% through month-end, while the VIX® increased in a
fairly steady fashion to end August at 26.41. Typically, the movements of the
equity market and the VIX® are inverse—the VIX® tends to
decline as the market trends upward and vice versa. Moreover, the tendency in
recent years has been for the VIX® to be well-below average when the
equity market is setting new all-time highs.
Source: Bloomberg, L.P.
What is causing the surprising behavior of the VIX® relative
to the price movement of the equity market? There are many factors that drive
volatility pricing, but one of the most interesting factors impacting the
current environment may well be the November 2020 election. As the pricing
curves for the VIX® futures contracts show, (Figure 2) the market
has been pricing in elevated volatility for contracts expiring near the
election. The October 31 contract has had a higher price than the
September 30 and August 31 contracts for most of the year, and October
volatility has been priced higher than the VIX® spot price (current
market price) since the end of May. Given the persistence of elevated futures
pricing, it is not surprising to see the VIX® climb as the election
approaches.
Source: Bloomberg, L.P.
The surprising
behavior of the VIX® has potential benefits for strategies that seek
to lower risk and enhance risk-adjusted return with index options. With the
record level of over-priced volatility in July and August, the risk-adjusted
return potential for option writing has never been higher. Even if the spread
between implied and realized volatility normalizes, either due to an uptick in
realized volatility or a resumption in the downtrend in the VIX®, a
positive spread between implied and realized volatility helps maintain
attractive return-per-unit of risk for option writing strategies.
Furthermore, the recent
uniqueness of the VIX® futures curve creates opportunities for
active option management to add value relative to passive or purely systematic
option strategies. Option contracts with expiration dates close to the November
2020 election currently have volatility price components that reflect the
volatility levels priced into the VIX® futures curve. However, the
higher levels of volatility in contracts expiring close to the election
relative to nearer-term expirations may not last. By opportunistically
extending expiration dates, active managers can benefit from expectations of
increasing volatility while equity market conditions remain relatively calm. Record
spreads between implied and realized volatility and the abnormality in the
shape of the volatility curve may not exist for passive and rules-based
strategies that do not happen to utilize contracts with exposure to these
potentially beneficial anomalies.
With implied
volatility levels still well above the long-term average, strategies that
combine equity market exposure with cash flow from writing index options may be
particularly attractive to investors interested in strategies that do not invest
in bonds but have less risk than pure equity investments. Since 1977, Gateway
has utilized a consistent yet flexible and active approach to lowering equity
market risk while benefiting from the unique attributes of index options in
pursuit of attractive risk-adjusted return.
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Quick Takes
Is Low Volatility Low Risk?
An "All Clear" Signal?
An Update on the Volatility Risk Premium (VRP)
Should Election Year Volatility Concern Investors?
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2019 Flagship (Index/RA) Commentary - Q3
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Active Overwrite Commentary
2020 Active Overwrite Commentary - Q3
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2019 Active Overwrite Commentary - Q4
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2020 Active PutWrite Commentary - Q1
2019 Active PutWrite Commentary - Q4
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