SSGA: Using volatility data from ETF options to monitor market risk

Apr 25th, 2019 | By | Category: ETF and Index News

By Matthew J. Bartolini, Head of SPDR Americas Research, State Street Global Advisors (SSGA).

Matthew J Bartolini, Head of SPDR Americas Research

Matthew J Bartolini, Head of SPDR Americas Research.

In an understandable attempt to measure market risk and sentiment, investors frequently turn to soft-data confidence polls or the CBOE Volatility Index (VIX Index), which is based on S&P 500 Index options. While these traditional tools can be helpful, we believe any risk-monitoring toolkit can be strengthened with the addition of high-frequency volatility data from the ETF options market.

As ETFs have amassed more assets under management, the ETF options market has also grown. The ETF options market is uniquely able to provide valuable intelligence on a wide swath of geographies, markets, and sectors, thanks to the prolific (and still-expanding) ETF product offering.

Investors of all types can learn to appreciate volatility signals from the ETF options market, harnessing them to cut through the noise and make better-informed investment decisions.

Volatility: What is it, and how is it measured?

There are two primary measures of options-related volatility:

  • Realized volatility (RV) represents historical price volatility measured over a specified period.
  • Implied volatility (IV) represents the market’s forward-looking expectation of volatility based on current options pricing.

For implied volatility, common methods for evaluating richness (above average) or cheapness (below average) are on a relative basis:

  • IV percentile is the percentile ranking of the current IV level against all its other measurements over a defined trailing period – usually one year. Applying a percentile provides an assessment of where the current implied volatility level sits relative to historical levels over the entire period.
  • IV range assesses the current IV relative to the high and low points during a given period. While IV percentile evaluates the current IV relative to all data points over the period, IV range evaluates the current level compared to just the high and low points – a differentiation that can be helpful when data points are clustered.

To see these concepts in action, let’s consider two examples using three-month at-the-money options pricing for illustrative purposes.

Example 1: Assessing risk in the oil and gas industry

The chart below illustrates three-month at-the-money IV for options tied to the SPDR S&P Oil & Gas Exploration & Production ETF (XOP US) over the past year, as of April 10, 2019.

On April 10, 2019, the IV was 30.7%, which is greater than or equal to over 61% of the daily observed levels in the previous year, and therefore above the median.

While currently plotting above the median may seem high, the current level of volatility is actually closer to the low end of the range (25.3%) than the high (49.5%), as a result of the sizable spike in December 2018.

Source: SSGA.

The takeaway: As the second quarter of 2019 got underway, the market’s forward-looking expectation of three-month volatility within the oil and gas industry was trending lower, but still above the median for the year – which isn’t necessarily a shock. The spot price of oil in the third quarter of 2018 reached its highest point since 2014. Soon after, however, renewed concerns of slowing growth potentially impacting demand while the oil market remained abundantly supplied sent the spot price falling like Icarus getting too close to the sun. As a result, the market’s expectation of forward-looking risk for firms highly sensitive to movements in the spot price spiked significantly. As the broader equity market has rallied, the spot price of oil has recovered and the fear of another oil shock circa 2015 has subsided.

We are keeping an eye on how this metric ebbs and flows as the market rally continues unfolding alongside the persistent slowing of economic momentum this late in the cycle.

Example 2: Examining implied vs. realized volatility

A comparison of realized and implied volatility can provide valuable historical context to certain periods. Remember: IV doesn’t foretell the direction of future market swings – it purely measures the expectation of future market swings. As such, IV can help identify potential forward-looking catalysts, signaling that more research is needed.

In the chart below, we depict a case study referencing the French elections from 2017, as options on the SPDR EURO STOXX 50 ETF (FEZ US) exhibited higher-trending IV, yet realized volatility remained subdued.

Source: SSGA.

The takeaway: Forward-looking IV increased to reflect uncertainty around European equities heading into the first round of French elections on April 23, 2017, even as movements in the equity markets were somewhat subdued. After the election, implied volatility and realized volatility met in the middle as uncertainty receded and the market swung to the upside.

Investors who take note of such gaps are provided with a launching point for further analysis of portfolio positioning if the risk event is indeed a market-moving opportunity. This is one trend we are watching as the Brexit drama continues to drag on. And right now, there is no similar gap between the IV and RV for FEZ, a likely byproduct of the markets suffering from “Brex-haustion.”

Expanding the risk-monitoring toolkit

In an environment characterized by heightened policy uncertainty, geopolitical tensions, and slowing growth, prudent investors are expanding their risk-monitoring toolkits. By leveraging information from the ETF options market, investors can gauge market expectations by asset class, geography or focus. As markets become more susceptible to impending risks, expectations of volatility implied in options on ETFs can help investors zero in on the catalysts most likely to impact their portfolios.

This post was written with contributions from Colin Ireland, Vice President, Senior Research Strategist, State Street Global Advisors.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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