Volatility cycles and stock trends

April 1, 2015 11:05 AM

Wall Street and Hollywood have many things in common, including a large number of well-compensated individuals, a global product reach and a propensity toward reruns and sequels. 

As a concept, volatility has existed in financial and insurance markets from their very beginning, but it really did not show up on traders’ proverbial radars until the launch of options trading and the acceptance of the Black-Scholes model in the mid-1970s. Some market veterans recall traders taking sheets of paper down to the floor of the Chicago Board Options Exchange each day to sidestep the calculation of implied volatility via a Newton-Raphson search algorithm. 

Volatility calculations eventually combined with indexation, another 1970s gift to humanity, to form the CBOE’s volatility index, or VIX. The VIX was based originally on the S&P 100 Index and a small set of near-the-money options for two months; eventually, it became a more robust calculation, based on the on-the-moneyness-weighted smile of S&P 500 options.

Regardless of construction, the VIX followed a pattern of jumping higher during market declines and easing lower during rallies. The reasons behind this asymmetric behavior are both simple and eternal: as most investors are long and not short equities, they seek to add put option protection against their holdings during market selloffs. They do not, however, flock into call options in lieu of long equity positions during bull markets.

Moreover, the skew of option volatility is related to market trends as well. Writers of equity and index put options—still one of the better strategies ever devised for losing vast sums within a short period—find they have to scramble to cover their contracts at a time when ordinary investors are looking to buy put options, not sell them. Finally, writers of variance swaps must sell increasing quantities of stock at ever-lower prices to hedge their positions. Variance is the square of volatility, and is therefore a far-better exploding cigar for those who have not kicked the habit.

None of this compares in importance to the rotation of the earth, though. As one market opens and another closes, rallies and selloffs are transmitted from one to another in a predictable time sequence. The most important period for this transmission is the overlap between European and U.S. markets. If the United States follows European markets, or if Europe reverses course following the United States’ opening, positions and volatility levels adjust in a sort of risk-on/risk-off arbitrage state of mind. Let’s isolate the VSTOXX, the common measure of European stock index volatility, from any sort of real-time spread analysis against U.S. equities and the VIX and focus instead on the VSTOXX and the Euro STOXX 50 index (SX5E).

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About the Author

Howard L. Simons is president of Rosewood Trading. @simonsresearch