VIX
The volatility index has been ticking up lately and is approaching 30 again. This was priced into the VIX future curve for quite sometime as markets were betting on election volatility. Regardless of your views on the election, the fact that options markets are currently pricing in a high amount of volatility can often lead to daily volatility occurring even if nothing happened really that day.
A refresher is always needed when it comes to options and how institutions hedge them. If investors expect that there will be a really good or really bad outcome from the election (or both), they will buy a call or a put option (or both). This has the effect of raising the price for these options, which raises the implied level of volatility. The higher the option price, the higher the implied volatility. Higher prices often means there’s more flows directed into buying options than selling them, and this is very important.
When a dealer sells a call, they have to go buy the underlying stock (or index) to delta hedge it. If the stock rises, they have to buy more. If it falls, they sell some. When a dealer sells a put, they have to short the stock (or index) to hedge it. If the price falls, they short more (sell), and if it rises, they buy some back.
Do you see what’s happening here? Dealers are chasing the market. If a fundamental equity manager doesn’t like a stock anymore for whatever reason, they will sell it which moves the price down. Dealers now have to sell that stock as well to delta hedge, which moves price down further. This happens over the entire index as well as S&P 500 options are by far the highest volume option market. When the index rises a little bit for either a fundamental reason or just due to noise, dealers are pushing it up even more. The opposite is also true.
Let’s review our option greeks really quick. Delta is the change in price of an option given the change in price of the underlying. The second-order derivative of delta is what is known as “gamma”. It is the change in delta given the change in the price of the underlying. When dealers sell a bunch of options which leads them to have to buy when market is rising and sell when market is falling, it’s be cause deltas are rising and falling with the market. Since it’s not good to buy high and sell low, dealers are what is referred to as short gamma. They would make more money if the stock or index didn’t move much (deltas didn’t change).
When implied volatilities are high, that means the price of options are high. When the price of options are high, that implies there’s more option buyers than sellers. When there’s more option buyers than sellers, dealers are usually short gamma. When dealers are short gamma, they are buying as prices rise and selling when prices fall.
This ultimately means that the market is less liquid. It’s not easy to buy and sell large amounts of stock because if you move the market a little you may move it a lot. That’s why the VIX can be used as not only a barometer of market volatility but also market liquidity.
