The Current Market Environment
Secular inflation can actuate secular bear markets in equities … secular bull markets in commodities … secular volatility regimes and liquidity crises.
Until June 9, there was a rather muted volatility response to a bearish reversal in $SPX. In some part, this was related to investors having been relatively well-hedged (long puts) and perhaps at the same time under-estimating the sea change about to come.
The S&P 500 index is currently in a turbulent period and early phase of a brutish secular downtrend. In this context, relative volatility (RVOL) will be the dominant consideration when estimating the implied volatility (IV) of (high gamma) ATM options. Volatility in OTM strikes is likely to be excessive relative to that in ATM strikes.
This Is A Left Tail Event
Unexpected and significant changes in interest rates, high inflation, and equity volatility create tail events.
Tail risk represents the probability that the magnitude of returns on an asset or portfolio will exceed some threshold (usually 3 standard deviations) on a normal (Gaussian) distribution curve. But financial markets are non-normal.
A “fat tail” refers to a probability distribution … a distribution that obscures a fragile market experiencing extreme price movements … outliers … negative returns … accumulating asymmetrically about the mean . The tail on the left is also associated with conditions marked by higher than normal volatility of volatility and in turn, lower than normal portfolio returns.
Fat tails, negative skew, and jumps have deleterious effects on portfolio returns. Risk is located in the tail.
Taken together, fat left tail risk often shows up in down-trending auctions …marked by brief recovery rallies, and punctuated by sudden precipitous sell-offs. As SPX drops, RVOL and IV increase while skew widens as IVs become unstable. IV skew reflects the market’s expectation of higher RVOL. While it is difficult to establish relationships between asset prices and volatility in a skewed environment, higher skew generally portends a fatter left tail and an increased likelihood of high levels of IV during sell-offs.
Sticky Strikes and Sticky Skew
In quantitative trading, invariants are quantities that don’t change and are referred to as “sticky”. So sticky skew suggests that as the index moves, the skew at a given level remains relatively unchanged … invariant.
When markets are expected to experience periods characterized by intermittent range-bound auctions, the volatility skew for an option can remain relatively unchanged “with strike”. This behavior is referred to as the sticky strike rule. (The “sticky strike” model preserves the Black-Scholes-Merton valuation archetype.)
It has been noted that as the market recently began making appreciable moves down, skew in short-dated options was unusually invariant … less effected by market behavior … “sticky”. In other words, sticky skew is a way of thinking about the patterns of skew linked to market behavior. An anomalous increase in short-dated sticky skew might be considered a harbinger for a market that trades in confined ranges … then experiences sudden harrowing jumps … while RVOL grinds higher.
Conclusion: Intermediate-Term and Beyond
In summary, we have undeniably entered a bear market in equities … one characterized by a jumpy index … prone to acute and steep sell-offs. For reasons aforementioned, RVOL should be a dominant consideration when complementing a portfolio with tail risk hedges.
During such times, tactical asset allocation with long volatilty hedges outperform. In contrast, bonds have little to offer in the way of portfolio protection and as implied correlations rise, diversification benefits slump.
References
- Derman E. Regimes of Volatility (1999) Goldman Sachs Quantitative Strategies Research Notes
- Fat Tail Risk: What It Means and Why You Should Be Aware Of It | Nasdaq
- Taleb NN. Dynamic Hedging: Managing Vanilla and Exotic Options (1996) John Wiley & Sons
