Beware Friday's OPEX, JPMorgan Warns "Volatility Too Low, Disconnected From Fundamentals"
Many market participants are scratching their head as to whether the low VIX levels are an anomaly or some kind of utopian new normal. JPMorgan's Quant Derivatives shop warns the current environment is not similar to the great moderation of 2004-2007 as volatility appears to be disconnected from fundamentals and pressured by structural effects, including central bank intervention, low trading volumes, and pressure from option hedging. Crucially, based on an examination of 'gamma imbalances', the current (low) volatility regime may change significantly after the June expiry.
As JPMorgan explains...
Low Volatility – Anomaly or a New Normal? Many clients have asked us whether the low VIX levels (1M median: 11.7) are an anomaly or a new normal. We have heard analysts arguing that the low volatility is fundamentally justified and the current environment is similar to the 2004-2007 time period. To assess current levels of volatility, we have analyzed the VIX in light of recent Macro data, Volatility of other asset classes, and various structural drivers. Our view is that the current environment is not similar to 2004-2007 as volatility appears to be disconnected from fundamentals, and pressured by structural effects. In our recent report on the VIX, we analyzed the ability of employment, manufacturing, consumer and housing data to forecast the VIX. Most of these macro series indicate that the VIX is about 3 points too low (historical success rate of these forecasts was 60-70%). During the 2004-2007 time period, these same macro models showed the low levels of volatility at the time were fairly priced.
Volatility in other asset classes such as rates, FX, commodities and credit spreads have also been very low. Some of the measures (such as G7 FX, Rates, and Oil volatility) are in fact at absolute all-time lows (VIX is in the 25th percentile of the 2004-2007 low volatility range). The only exception is credit spreads which are moderately higher now than during 2004- \2007. In addition to low levels, most cross-asset volatility time series (85%) have been declining in the last month – a signal that does not point to an imminent increase in volatility.
To further understand the current low volatility levels and compare it to the 2004-2007 time period, we looked at levels of market activity and structural drivers of volatility. Firstly, there is much less trading activity now as compared to the 2004-2007 time period.
Figure 3 below shows a nearly 50% decline of equity share volumes since 2007. Volume and volatility are highly correlated (Figure 4, current low volumes/volatility are denoted with a red dot). Volatility and volumes are linked by a positive feedback loop (lower volumes lead to lower volatility and vice versa).
Lower market activity is likely due to relative decline in activity of levered investors such as hedge funds and prop desks, and relative increase from less active investors such as corporates performing buybacks, or asset managers increasing equity allocations. Relatively high valuation of equities is also not supportive of higher volumes and volatility, as value-driven investors gradually step away from the market. Low realized volatility and the low yield environment further invite volatility sellers of all shapes and forms which is putting further pressure on implied volatility measures such as the VIX.
In addition to low trading activity and option selling, volatility has been under pressure from the hedging of options. Figure 5 above shows the S&P 500 call-put gamma imbalance that has recently reached all-time high levels. Gamma (per 1% S&P 500 move) of call options was $25bn higher than the gamma of put options last week. As investors on average tend to sell call options and buy put options, hedging of these positions puts pressure on realized volatility and this pressure is higher than it has ever been.
In summary, we see the current market environment as different from 2004-2007. Volatility appears to be too low and disconnected from fundamentals. However, the low yield environment and support from central banks is currently keeping volatility low not just in equities but across asset classes.
Additionally, equity volatility has been held down by low trading activity and option hedging pressure. As we will discuss below, some of the option-related pressure on volatility will abate after the June expiry, which could result in higher realized volatility.
One more thing...
Option Expiration: About $900bn of S&P 500 option notional is expiring this Friday.
The current ratio of Put to Call contracts outstanding is ~2 which is near all-time high levels (98th percentile over the past 15 years). The high ratio of Puts to Calls may on the surface suggest that investors are well hedged and bracing for a market decline. However this is not the case as most of the put options are far out of money and ineffective at current market levels. Figure 9 below shows S&P 500 options open interest by strike. Currently, ~80% of put open interest is below the 1850 strike and would not be an effective hedge for a ~100 point market pullback. This is also illustrated by the directional exposure (delta) of put options that is only ~$40bn (on ~$650bn of June Put notional open interest, i.e. the average delta for all June puts outstanding is only ~6%).
While it is hard to forecast if and how investors will roll these put options, the directional impact of rolling protection to higher strikes could have a negative impact on the market. Assuming naively that clients are long puts and short calls and roll all June options (calls and puts) 3 months out and 100 points higher, this would lead to an incremental change in total delta of negative ~$100bn of S&P 500.
Despite the high put-call ratio, the total gamma of calls is currently ~$15bn larger than the gamma of puts, which is pressuring realized volatility lower. However, about $10bn of this call imbalance will expire on Friday, leaving more balanced gamma positions thereafter. In addition, we think that if a significant amount of June puts (~$650bn of put notional) is rolled to higher strikes, it will further increase the put gamma. This in turn would be supportive of higher realized volatility post June expiry compared to realized volatility over the past month.
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