Inside Volatility Trading: Everyone Has a Plan Until…

Thirty years ago (February 11, 1990) Buster Douglas shocked the world when he knocked out Mike Tyson in the 10th round of their Tokyo bout. Tyson came into the fight as the undefeated and undisputed heavyweight champion of the world. He had 37 wins, 0 losses and had never been knocked down. Douglas had lost his previous fight, his mother had passed away three weeks prior, and was listed as a 42:1 longshot.

Mike Tyson had an air of invincibility and arguably underestimated the threat of a fearless and motivated Buster Douglas. For those inclined, there’s a wonderful ESPN 30 for 30 film documenting the fight.

Source: Tsugufumi Matsumoto/AP

Three weeks ago the S&P 500® Index was swaggering to new all-time highs and the economy was seemingly on sure footing. As we referenced in our previous newsletter, the collective market consciousness expressed a “What, Me Worry?” mentality.

Since the late 2018 equity swoon, US markets, particularly the dominant large cap leaders (MSFT, AAPL, AMZN, FB, etc.) have performed like champions. The S&P 500 got off the proverbial canvas in 2019 and has suffered through just a few “body shots” over the last 13 months. Most recently, global markets staggered as concerns about the coronavirus spread.

Source: LiveVol Pro

Markets have regained their balance in recent sessions and refocused on the global growth story combined with easy monetary policies and persistently low inflation measures. Following a sharp 3.7% pullback the S&P 500 Index moved to new all-time highs on February 6. The recent spate of pillar-to-post trade heightened both realized and forward-looking expectations for volatility.

Source: MS Research

Perhaps the latest “V-shaped” recovery was abetted by the visual above which was part of the Wall Street Journal’s Daily Shot and Morgan Stanley Research. The data highlights the tendency for broad market resilience in the face of other potential epidemics. The MSCI World Index on average has positive returns across one/three/and six month durations following the threats posed by everything from HIV/AIDS (1981) to the measles outbreak last year (2019).

The fact of the matter is (to paraphrase Donald Rumsfeld) we don’t know what we don’t know ̶ that reality is arguably what makes derivative markets so powerful. Tools like index options and volatility products afford end users the ability to shape the potential narrative over a given time frame.

An election year introduces a variety of “known unknowns” and 2020 is case in point. The VIX futures curve has seemingly been indicating a greater degree of uncertainty for late 2020 as evidenced by the persistent “kink” in the October contract.

Source: LiveVol Pro

In a related, albeit more front of mind story, the SPX options market seem to be pricing in potential volatility related to Super Tuesday on March 3. On that date, Democrats will allocate 1,345 delegates as 14 states, American Samoa, and Democrats Abroad will hold primaries. By the end of March, about two-thirds of all the delegates will have been designated. Over the past handful of Presidential election cycles, the major parties have had a “presumptive nominee” by springtime.

Source: Cboe Global Markets & Bloomberg

SPX options and VIX futures are, at least anecdotally, responsive to the perceived likelihood of a progressive Democratic nominee (Warren/Sanders) versus a centrist candidate (Biden/Buttigieg/Bloomberg/Klobuchar). The SPX forward volatility curve indicates the potential for a spike in realized volatility on/around Super Tuesday.

With sports and politics serving up relatable analogies, it’s no surprise investors, traders, and market pundits* have a tendency to project these themes onto their descriptions of the market. How often have you heard or read: “we’re in the 8th inning of the cycle” or “we’re happy to hit singles and doubles”? Yuval Noah Harari contends that humans are the only species that believes in stories and it’s enabled our unique ability to cooperate.

The narrative right now involves an unflappable S&P 500, an uncertain political landscape, a quickly spreading respiratory virus, and central banks that remain committed to fighting signs of deflation wherever they appear.

We have derivative markets that have been incredibly active including the busiest January in history. Futures and options are pricing in potential points of greater uncertainty in both the near term as well as further out.

Time will tell whether a longshot candidate takes down a frontrunner just as Buster Douglas did 30 years ago. Derivative markets make it possible to manage the risks whether they’re geopolitical in nature or not. While there is no futures or options product to insulate yourself against Iron Mike Tyson, the derivative markets allow us to “put up our guard” if we deem it necessary. 

Reporter: “I hear your opponent has a clever plan for defensing your left hook. How do you respond?”

Mike Tyson: “Everyone has a plan until they get punched in the mouth.”

Clearly it’s great to have a plan – and it’s essential to have the right tools to implement it.

To learn more about index options and the volatility markets or network with others that operate in the space, join us at Cboe’s annual Cboe Risk Management Conference (RMC) in Bonita Springs, Florida starting March 2.

*Potentially including myself in these ranks

VOLATILITY NEWS

• Schaeffer's Investment Reseach: Take Advantage of the Sharp Volatility Pullback
• Bloomberg: Stock Traders Are Dumping Virus Hedges After 'Peak Fear' Passes
• The Wall Street Journal: Why a Rising 'Black Swan' Index Could Be a Sign of Bullishness
• Reuters: From Black Swan to Bubble: As Virus Concerns Fade, Investors Worry About a Melt-Up
• Politics and Money: Options Action Ahead of the 2020 Election
• Bloomberg: Wall Street Gauges of Virus Fear, From Volatility to Dr. Copper
• Barron's: It's Time to Make a Bigger Bet on China's Rebound
• OCC.com: OCC Cleared Contract Volume Highest January on Record

NOTABLE TRADES

Video: The VIX Index Rises on S&P 500 Dip

Cboe Will Be Attending: 

February 15, TD Ameritrade Market Drive Event in Scottsdale, AZ