In recent weeks, we have seen a very unusual pattern in the S&P 500 and the Vix, which measures (implied) expected volatility. These indices normally have a negative correlation: as volatility rises, stocks tend to fall – and vice versa. But surprisingly they have moved in tandem since late August. Why is that?
First, let's look at why the correlation is normally negative. Usually, stock markets are slow and steady on their way up while crashes are abrupt and deeper. This means that on average volatility is lower when the S&P 500 gains than when it falls. It also means that the demand for a measure of protection (through put options) tends to increase sharply in falling markets, pushing option premiums higher, which again results in higher implied volatility.
So what was different in late August? The S&P 500 marked a historic high and kept on rising afterwards. First, higher daily moves translated almost directly into higher option prices (and thus a higher Vix).Second, the demand for options increased from two sides: investors afraid to miss out on a rally tried to jump on the band wagon; and investors worried the rally was going too far too fast sought to protect their gains by buying put options. Higher demand for options means higher premiums, which means a higher Vix. There is also the potential for a self-enforcing upward spiral between the cash and options markets (while it is never clear what is the hen and what is the egg). The options market was certainly a significant driver in the recent U.S. stock-market rally.
In our view, the extraordinary thing about the rally is the exploding demand for options as a new wave of retail investors (Millennials whose interest in trading was aroused during the lockdown or users of new trading apps) discovered the instrument and succumbed to the charms of the leverage it offers. Also unusual this year is the amount of options traded on single names, above all the Tech heavyweights. But with trading volumes in some of these options having almost tripled compared to 2019, it is probable that institutional investors have also played a role here.
What do we make of all this? Well, we would expect demand for options to remain elevated going forward. The correction has been rather mild so far. Therefore, valuations are still fairly rich, and demand for downside protection remains elevated. Other potential reasons keeping investors nervous are the upcoming U.S. elections, the escalating U.S.-China dispute and Brexit. In any case, the past couple of weeks should serve as a reminder that there is a good reason for equities’ risk premium over government bonds. They are more volatile, and therefore more risky. As Thomas Bucher, DWS Equity Strategist, puts it: "The low-interest-rate environment and impressive earnings resilience of big Tech companies throughout the pandemic certainly justifies above-average valuations, especially for this part of the market. But it doesn't mean the end of the equity risk premium."
Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 9/11/20
Appendix: Performance over the past 5 years (12-month periods)
|08/15 - 08/16||08/16 - 08/17||08/17 - 08/18||08/18 - 08/19||08/19 - 08/20|
Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 8/31/20
Past performance is not indicative of future returns.
2. The historic (or realized) volatility serves as the anchor for options prices used to derive the implied volatility, which the Vix represents. With increasing daily moves, the historic volatility increases, leading to higher options prices and a higher Vix
3. Typical signs of increasing retail share of option trading are shorter maturities and smaller sizes, which have been seen this year.