Option Prices are Singing

[00:00:01] Hello, this is Dean Curnutt and welcome to the Alpha Exchange, where we explore topics in financial markets associated with managing risk, generating return, and the deployment of capital in the alternative investment industry.

[00:00:19] The fourth quarter is here. The market may have been largely unchanged this week, but as the weekend is upon us, there's much insight to be gleaned through the study of price. Stanley Druckenmiller has said that, quote, the best economist I know is the stock market.

[00:00:34] I always took this to mean that market prices, while imperfect, messy, and prone to distortion, are the clearest window with which to glimpse into the future.

[00:00:43] I'll take prices any day of the week over actual economists, even very smart ones, filling out a survey about GDP four quarters ahead.

[00:00:52] Option prices, by incorporating time, the expiration, and distance, the strike, give us many more dimensions than a mere flat price like the S&P or a single stock.

[00:01:03] Perhaps it's the options market that is truly the best economist.

[00:01:07] There's so much to study in option prices.

[00:01:10] For me, first and foremost, it is the investigation of the time variation of risk premium.

[00:01:16] This is a fancy way of trying to answer the question, what makes the VIX go up and down?

[00:01:21] This brings in so many related variables, like realized volatility, the business and financial cycles, Fed policy, positioning, and credit spreads.

[00:01:29] If the stock market speaks, then the options market sings.

[00:01:33] Now, I'm not aware of any derivatives trading unit at Jordan Belfort's Stratton Oatmok, but there is an amazing scene in Wolf of Wall Street in which Donnie, played by Jonah Hill, screams at Brad, John Bernthal.

[00:01:47] He says, I'll sing, threatening to go to the cops.

[00:01:51] I've always loved that slang use of the word sing.

[00:01:53] It's my strong contention that option prices are singing out loud right now.

[00:01:59] Now, they aren't ratting on anyone, but they are begging for our attention.

[00:02:04] And that, good listeners, is the subject at hand in this 15-minute podcast.

[00:02:09] In 2,000 words, it's my objective to shine some light on these prices and share some of the inferences I believe emerge.

[00:02:16] I want to start by bringing in hack comedian Kenny Banya from Seinfeld, who, in approving of a joke, said,

[00:02:24] That's gold, Jerry, gold.

[00:02:26] It was 100 years ago, in 1924, that Keynes called gold the barbarous relic.

[00:02:32] To be fair, gold bars don't fit neatly into one's back pocket, nor do they lend themselves to paying for groceries.

[00:02:40] But gold does have a number of factors going for it.

[00:02:43] First, it's kind of taken the place of government bonds in central bank QE programs.

[00:02:48] Turkey, India, China, they are all steadily accumulating gold.

[00:02:52] It's good to have a price-insensitive, deep-pocketed buyer alongside you.

[00:02:58] Just ask the 10-year note.

[00:02:59] This demand matters because, unlike the flood of government IOUs coming our way, gold is scarce.

[00:03:06] It's also clearly trending.

[00:03:09] Trending assets, either up or down, continue to trend.

[00:03:12] The correlation of properties of gold come and go.

[00:03:15] I wouldn't call them all that reliable.

[00:03:17] Is gold a portfolio diversifier?

[00:03:20] Yes.

[00:03:20] Has it been almost 30% positively correlated to the S&P on a daily return basis this year?

[00:03:27] Yes, also.

[00:03:28] But I will say that gold often takes on an anti-S&P quality when you need it to, during periods of chaos.

[00:03:35] That is really important.

[00:03:36] Of the 37 days when the S&P fell by 4% or more since 2006, the GLD is, on average, flat on those days.

[00:03:46] Gold is a unique asset, and its vol can expand on both rallies and sell-offs.

[00:03:51] The two recent big pops in gold vol are not really a function of gold, but more of the general environment for risk.

[00:03:58] We all know about August 5th.

[00:04:01] The GVZ, the VIX for gold, rose 17.4% that day.

[00:04:05] Not a 65% pop, as was seen in the VIX, but pretty large in its own right.

[00:04:12] And back on April 15th, perhaps in tax day protests, the GVZ surged by 10%.

[00:04:18] On that same day, the GLD rose 1.9%, the S&P fell by 1.2%, and the VIX ramped by 11%.

[00:04:26] It's hard not to be doing a lot of thinking about gold.

[00:04:30] It's convex, uncorrelated, trending, and scarce.

[00:04:34] It has a particular place in a portfolio to defend against government chaos.

[00:04:39] Here's a quick stat.

[00:04:41] The GLD has been up 1% or more on 458 days since 2010.

[00:04:46] But only 29 of them, October 1st being one, have occurred when the DXY, the dollar, was up by 50 basis points or more on the same day.

[00:04:55] The market may be telling us something about geopolitical risk.

[00:05:00] It's worth noting that there were a string of gold-up, dollar-up moves in concert as Putin invaded Ukraine in March of 2022.

[00:05:08] Next, I want to talk about oil and its VIX index, the OVX.

[00:05:14] We are supposed to read what market prices are telling us about the state of risk, and I will point to the oil VIX as quite interesting.

[00:05:21] The OVX was up 17% on Thursday, October 3rd, on a 4% up move in the oil ETF, the USO.

[00:05:30] The SIBO uses the classic VIX calc to produce the OVX.

[00:05:34] Vol nerds will know that the VIX was redesigned in 2004 as a more holistic calculation that took in a wide swath of option prices and strikes as inputs,

[00:05:45] with the purpose of mimicking the hedge portfolio for a one-month variance swap on the S&P.

[00:05:51] Because the SPX has a put skew and the VIX calc needs a higher weight to out-of-the-money puts to replicate a variance swap hedge,

[00:06:00] the VIX always trades at a premium to one month at the money implied vol on the S&P.

[00:06:05] But in oil, we are, at least for now, concerned about the call side of things.

[00:06:10] There has been a steady and significant increase in vol across all strikes in November WTI options.

[00:06:16] But it is the upside, low delta call vol that has seen the largest repricing.

[00:06:22] By the manner in which the VIX is calculated, it can be argued that the OVX underestimates the true increase in call implied volatility.

[00:06:32] I say a lot that equities are short the straddle on rates.

[00:06:36] Show me scenarios in which rates got shocked up or down in a very short period of time and equities are very likely lower.

[00:06:43] I think we can say the same about crude.

[00:06:46] Clearly, the April 2020 meltdown in oil prices brought about spectacular levels of both realized and implied volatility.

[00:06:53] That's the put side.

[00:06:55] Currently, we are dealing with the call crude up part of the straddle.

[00:07:00] I wonder if the surge in implied vol on crude and especially the increase in call skew may be seeping into the S&P.

[00:07:06] The real premium increase in the price of out-of-the-money calls on crude is telling us that low probability outcomes, i.e. very high prices for crude, are being respected.

[00:07:17] For context, a November 80% put on WTI, the 59 strike, cost $0.08.

[00:07:23] The 120% call, the 89 strike, cost just under eight times that amount.

[00:07:30] The 80-120 skew looks to be in the 100th percentile.

[00:07:34] That is, call vol being greater than put vol.

[00:07:37] On Thursday, the USO was up 4%, the OVX up 17%, and the VIX up 7%.

[00:07:43] Last time that happened, October 13th, 2023.

[00:07:48] Incredibly, the VIX on October 13th, 2023 was 20.37, and on Thursday, it closed at 20.49.

[00:07:57] With the S&P barely moving, but index implied vol very well bid, it's plausibly the case that geopolitical fears are spilling over.

[00:08:05] Vol goes up and down for lots of reasons.

[00:08:07] The primary driver is carry, which is all about realized vol.

[00:08:11] Vol. That's not what's driving the VIX right now, as the vol risk premium is at exceptionally high levels.

[00:08:17] At 12, the premium of the VIX to two-week realized volatility in the S&P is a 100th percentile kind of thing.

[00:08:25] I've argued for a few months now that the US election has threatened to reduce the supply of vol in the market.

[00:08:32] All else equal, the clearing price rises when supply is withdrawn.

[00:08:36] Let's add geopolitical risk to this list of very pesky unknowns that simply do not lend themselves to an at-NPV discounted cash flow analysis exercise in Excel.

[00:08:49] While the way in which an option carries will ultimately play the largest role in setting its price, there are times when supply and demand factors can overwhelm the basic economics of carry.

[00:08:59] When the vol community is faced with an onslaught of premium, option prices are pushed lower.

[00:09:05] I'm recalling, and dating myself here, a clever trade that JP Morgan did back in 2003 that enabled employees of Microsoft to monetize their employee stock options.

[00:09:16] The take-up was much more than anticipated, and JP Morgan originally thought they'd bought some very cheap vol from folks who just wanted to monetize, get some money for their stock awards.

[00:09:28] The fine traders at Jamie Dimon's shop soon found themselves overindulging Greeks like Gamma and Vega.

[00:09:34] At one point, Microsoft vol traded below S&P vol, something I can't recall ever seeing outside of a financial crisis.

[00:09:42] The opposite is true as well. Implied vol can get really inflated without necessarily being empowered by realized vol.

[00:09:49] We find ourselves in such a position currently.

[00:09:52] Let me share some further thoughts on the prices I see and what they mean to me.

[00:09:56] Some of this is simply recasting what I've posted on Twitter recently.

[00:10:01] First, let's start with the extreme levels of uncorrelation among equities.

[00:10:05] That is, realized correlation among stocks over the last year is 15%.

[00:10:10] In the second percentile over the last 10 years.

[00:10:14] This has exerted substantial downward pressure on realized volatility at the index level.

[00:10:20] Because realized correlation is so low, so is implied correlation.

[00:10:24] Three-month IC on the S&P is 21% in the seventh percentile over the last decade.

[00:10:33] Below the surface, however, the market has started to reprice upside versus downside implied correlation.

[00:10:39] Here we can look at the spread between three-month implied correlation at the 10 delta point on the put side and the 10 delta point on the call side.

[00:10:49] In 2022, while implied correlation was in the 50s, the market ascribed almost as much upside implied correlation, that is, to the 10 delta call,

[00:10:59] as it did to downside implied correlation, that is, to the 10 delta put.

[00:11:04] Now, with implied correlation much lower currently, the spread of downside to upside is much higher at 37 points.

[00:11:12] Excluding August 5th, you've got to go all the way back to May of 2022 to find a spread so large.

[00:11:19] You'll note that that was just before the Fed started embarking on its tightening cycle.

[00:11:23] The market, I believe, is telling us something about downside risk, certainly to some degree the result of the chaos of August 5th.

[00:11:32] Next, the VIX beta has been very strong.

[00:11:35] On September 27th, the VIX moved up 10.5% on a nearly unchanged S&P.

[00:11:41] A few days later, on October 1st, it moved up 15% on a 90 basis points decline in the S&P.

[00:11:49] These are very large reactions involved for a relatively tame move in the underlying stock index.

[00:11:55] I've talked a lot about this re-energized VIX beta after an abysmal 2022 and 2023.

[00:12:03] In fact, in 2022, the S&P fell 19% and a VIX ETF, the VIXY, fell 25%.

[00:12:11] So much for using puts to hedge.

[00:12:14] If we regress the VIX versus the S&P from 2022 to August of 2024, we see a pretty muted slope, roughly 4x.

[00:12:24] That is a four times move in VIX per 1% move in the S&P.

[00:12:29] Since August of 2024, however, the beta has expanded to around 12.

[00:12:35] These betas are much higher recently.

[00:12:37] But what is more meaningful is the up versus down beta.

[00:12:41] That's really widened out.

[00:12:42] If you use the VIX, and here I mean futures and options on the VIX, as a hedge, you want it to pop when the S&P falls, but not plummet when the S&P rises.

[00:12:53] That is actually what we're seeing right now.

[00:12:55] And a big part of the argument that even if the VIX wasn't set to rise sharply, we were close to a floor at 17.

[00:13:04] That asymmetry, I think, speaks to some fragility in risk-taking and unwillingness to let vol go below a certain level ahead of the U.S. election and, what sadly, is clearly evidence of escalation in the Middle East.

[00:13:18] There's demand for VIX options, and it can be seen in how the VIX for the VIX, that is the VIX, is behaving.

[00:13:25] Just as the VIX has had a strong beta to the S&P, so has the VIX, which ramped 13% on Friday, September 27th, when the S&P was basically unchanged.

[00:13:37] The VIX has had strong moves versus the S&P.

[00:13:40] It's also had strong moves versus the VIX.

[00:13:43] Of the 88 times the VIX has risen 13% or more, only nine of them, September 27th being one of them, have occurred when the VIX failed to rise by more than 10.5%.

[00:13:55] So the VIX beta to the VIX has also been pretty interesting and kind of strong recently.

[00:14:01] This is not meant to be bullish or bearish.

[00:14:04] All right, well, you got me.

[00:14:05] A tad bearish.

[00:14:06] Stock prices at all-time highs do not have much margin of safety in this environment.

[00:14:11] But what I'm really hoping to do is highlight that hedging costs can be a function of the market's ability to provide the capital to absorb loss.

[00:14:19] The election and potential turning point in the economy, along with the sad state of geopolitical risk globally, make this more challenging.

[00:14:28] All else equal, the clearing price of an asset, vol being one of them, rises when supply is withdrawn.

[00:14:35] When hedging costs become too high, the only reasonable hedge becomes selling.

[00:14:40] We're not there just yet and hopefully won't get there.

[00:14:43] But there appears to be steady interest in accumulating insurance.

[00:14:47] Last point as I come up on my 2,000-word limit.

[00:14:50] As Q3 ended, the quarterly large S&P put spread collar got rolled out to September.

[00:14:57] Forget the call aside, I say, but that 9580 put spread is quite reasonable at 110 basis points, out to year end, in a market at its all-time high, with so much uncertainty coming its way.

[00:15:09] I wish you an outstanding week, month, and quarter.

[00:15:13] Till next time.

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