Persistent low levels for the CBOE VIX index have raised eyebrows among investors and analysts alike. The Bank for International Settlements (BIS), headquartered in Basel, Switzerland, has shed light on a potential reason behind this phenomenon in its recent quarterly report.
Shift Towards Yield-Enhanced ETFs
The BIS suggests that the current low VIX levels may be attributed to a growing trend among investors – the penchant for yield-enhanced exchange traded funds (ETFs). These structured products offer higher returns by selling options, contrasting with retail traders’ typical preference for short-term options.
Exploring Options Trading Dynamics
Options play a crucial role in the financial markets, granting investors the flexibility to buy or sell underlying assets within defined parameters. The CBOE VIX index, which tracks expected equity market volatility, is derived from the pricing of one-month options on the S&P 500 index.
Unusual Volatility Patterns
Despite ongoing uncertainties related to interest rates and geopolitical tensions, the BIS points out a peculiar trend. The VIX has remained below its long-term average, around 20, throughout most of 2023. This abnormal compression in equity market volatility has left experts scratching their heads.
Rise of 0DTE Options
An interesting development in the options market has been the surge in trading of one-day to expiry options (0DTEs) by retail investors. This shift towards ultra short-term derivatives, offering high leverage and lottery-like payoff potential, has significantly impacted trading volumes.
Impact on VIX Levels
The popularity of 0DTE options has grown exponentially, accounting for over 50% of SPX options’ trading volume by August 2023. While some attribute the drop in VIX to this trend, experts at the BIS argue that this alone cannot explain the sustained low volatility levels.
In conclusion, the dynamics of options trading, particularly the rise of yield-enhanced ETFs and 0DTE options, have reshaped the landscape of market volatility. As investors navigate these shifting trends, understanding the underlying factors driving VIX levels remains paramount.
Understanding Options Market Dynamics
One-Month Options vs. 0DTEs
Experts highlight that despite growth in both instruments, one-month options are still predominantly favored over 0DTEs for obtaining exposure to the market index itself. This choice is crucial as it impacts the pricing and volatility of the market.
Impact of 0DTE Trading
Interestingly, trading activity in 0DTEs does not directly influence the pricing of one-month options and subsequently the VIX. This is due to the difference in maturity periods, with one-month options expiring a day after trading.
Shift in VIX Futures Demand
While the selling of VIX futures in short-VIX ETFs led to lower volatility readings in 2017-18, recent years have witnessed a shift towards net positive demand for VIX futures. This change is reflected in increased fund flows into covered call ETFs, contributing to a subdued VIX environment.
Rise of Covered Call Products
Among yield-enhancing structured products, the covered call strategy stands out as one popular option. This approach involves purchasing the S&P 500 index while simultaneously selling a one-month call option on the same index. The proceeds from selling the call option, backed by ownership of the underlying index, boost the ETF’s income.
Impact on Volatility
The surge in yield-enhancing structured products, such as covered calls, not only leads to increased call sales but also affects how dealers hedge option exposures. Through dynamic hedging, dealers counteract market movements by buying when the index drops and selling when it rises. This contrarian approach helps to dampen price fluctuations in the underlying asset, subsequently lowering option prices as volatility decreases.
Conclusion
According to Todorov and Vilkov, these market dynamics offer insights into why the VIX may remain low even amid heightened uncertainty. The interplay between option instruments and dealer actions showcases how market forces can influence volatility levels in unexpected ways.
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