Seems that the cold came back here, nevertheless the coffe in Friday’s afternoon after work with TLBS is a must, not in the outside this time… thanks for another tremendous article!
It is rewarding to know that reading my silly thoughts is a part of your routine. I was fortunate enough to spend the last couple days in sunny Florida though now am heading back to the cold as well.
Really educational - thanks for showing the correlation, and the importance, of VIX to ERP.
Now if only we had a crystal ball showing VIX closing prices for any given day.
Did you backtest these correlations during your research? I wonder if you could see VIX being tied more closely with ERP today than it was, say in the 2000s - or was the correlation always in the same band? Ie. has volatility trading become more prevalent in the last decade?
Yes that crystal ball would be helpful for a lot of things.
I haven't run a back test to see how this correlates over longer periods, but I had a similar thought. My guess would be that volatility has become more important over time but I'm not sure. The ERP always felt a little bit like mixing apples and oranges between debt and equity to me anyways.
Thanks - I assume due to the massive increase in options volume/trading and esp. since the Lockdown trading all time highs it might have indeed become what's actually driving most of the price action seen in (at least highly traded options) stocks.
Just a guess though on my part having seen some crazy moves that must have been options unwinding mostly.
Always happy to read your posts since they are highly educational and giving different angles on market movements or macro.
It can and should get way more mathy than the charts presented here, if you wanted to use this concept to help guide trading. Here I just choose round numbers VIX closing levels (15/20/25/30) and plotted on a chart to demonstrate the point visually. If you wanted to develop a more robust model, you could consider all VIX levels and create a more statistically robust regression.
Thx for the great post, would you mind goin into details of constructing the fixed vol strike? That sounds a bit “unintuitive” to me compared to the concept of fixed strike vol.
The construction is very simple, just plot market prices IF VIX=[25]. The idea is pretty simple - just looking at where the market priced when vol was at a given level. I.e where did the market close last time VIX closed at [25] and what does that tell us about the direction of the market
This is really interesting. Would this imply that a drop in prices in spx accompanied by flat vix means the market is pricing in a deterioration in fundamentals? Maybe I need to re-read, but haven’t thought of the markets from this perspective before.
A drop in the SPX means investors don't want to hold equities.
A flat VIX means that people aren't willing to change the price they're paying for puts.
That's literally all. You can pontificate about the reasons they're doing it all you want, but the VIX won't say anything about why and they'll probably have different reasons every time. That's all circumstantial evidence you have to make guesses on.
Does demand for equities impact the price of puts? (yes)
Does demand for puts impact the price of equities? (yes)
It’s not circumstantial, it’s a strongly held correlation that increases with more dramatic price moves, with a well understood mechanism of transfer between the two
I think we essentially said the same thing, but took different paths to get there.
And I'd argue that if you want to see how demand for puts impacts the price of equities you'd be much better off tracking option deltas than the VIX.
Does demand for equities impact the price of puts? No not really. I would love to see a study on that.
Correlation is not causation.
VIX goes down when SPY goes up because people are bullish. When you're bullish you buy equities and sell puts. When you buy equities SPY goes up, when you sell puts VIX goes down.
The strongly held correlation is that when people are bullish they do both of those things at the same time. You can't read more into that because the VIX is just a mechanical representation of implied volatility based on market makers models.
Not even true implied volatility, it's like 5 to 1 put implied volatility versus call volatility or something ridiculous like that. I haven't looked in a while to remember the exact ratio.
I feel like you'd have more success arguing from the point of treasuries versus equities because those have different demands for each that definitely could still result in causal relationships.
In fact, if you don't mind my saying that would be a really interesting topic. Though perhaps not something you prefer to write about. Just something that I'll probably go look for studies on now. So anyways, thanks for putting the idea in my head! I'm looking forward to your next piece.
I agree it sounds like we agree on alot but are coming to different conclusions. Does demand for equities impact the price of puts? Absolutely - to the extent that demand for equities change the price of equity, they also inherently change the price (and delta) of puts.
In any case, happy to have sparked some ideas from you and would look forward to read them if you ever decide to publish them. Cheers!
Such a nice post! Thanks Bear!
Any source where to find a fixed-vol strike chart of the market?
I made up the term for this post - though I’m sure someone else has done a similar exercise previously
Seems that the cold came back here, nevertheless the coffe in Friday’s afternoon after work with TLBS is a must, not in the outside this time… thanks for another tremendous article!
It is rewarding to know that reading my silly thoughts is a part of your routine. I was fortunate enough to spend the last couple days in sunny Florida though now am heading back to the cold as well.
Your insights are always appreciated, even better if it’s sunny outside ;)
Thanks Bear, how do you apply this to an individual stock? Do you use Std. Deviation, option spread or something else?
All the best!
Really educational - thanks for showing the correlation, and the importance, of VIX to ERP.
Now if only we had a crystal ball showing VIX closing prices for any given day.
Did you backtest these correlations during your research? I wonder if you could see VIX being tied more closely with ERP today than it was, say in the 2000s - or was the correlation always in the same band? Ie. has volatility trading become more prevalent in the last decade?
Yes that crystal ball would be helpful for a lot of things.
I haven't run a back test to see how this correlates over longer periods, but I had a similar thought. My guess would be that volatility has become more important over time but I'm not sure. The ERP always felt a little bit like mixing apples and oranges between debt and equity to me anyways.
Thanks as always for reading!
Thanks - I assume due to the massive increase in options volume/trading and esp. since the Lockdown trading all time highs it might have indeed become what's actually driving most of the price action seen in (at least highly traded options) stocks.
Just a guess though on my part having seen some crazy moves that must have been options unwinding mostly.
Always happy to read your posts since they are highly educational and giving different angles on market movements or macro.
How did you normalize for Vix though? How mathy can it get?
It can and should get way more mathy than the charts presented here, if you wanted to use this concept to help guide trading. Here I just choose round numbers VIX closing levels (15/20/25/30) and plotted on a chart to demonstrate the point visually. If you wanted to develop a more robust model, you could consider all VIX levels and create a more statistically robust regression.
Thx for the great post, would you mind goin into details of constructing the fixed vol strike? That sounds a bit “unintuitive” to me compared to the concept of fixed strike vol.
The construction is very simple, just plot market prices IF VIX=[25]. The idea is pretty simple - just looking at where the market priced when vol was at a given level. I.e where did the market close last time VIX closed at [25] and what does that tell us about the direction of the market
Crazy good!
Glad you enjoyed and thanks for reading!
This is really interesting. Would this imply that a drop in prices in spx accompanied by flat vix means the market is pricing in a deterioration in fundamentals? Maybe I need to re-read, but haven’t thought of the markets from this perspective before.
I think it depends on the timeframe. In a day, probably not but over the course of months, I think so
I wouldn't read too heavily into the VIX.
A drop in the SPX means investors don't want to hold equities.
A flat VIX means that people aren't willing to change the price they're paying for puts.
That's literally all. You can pontificate about the reasons they're doing it all you want, but the VIX won't say anything about why and they'll probably have different reasons every time. That's all circumstantial evidence you have to make guesses on.
Does demand for equities impact the price of puts? (yes)
Does demand for puts impact the price of equities? (yes)
It’s not circumstantial, it’s a strongly held correlation that increases with more dramatic price moves, with a well understood mechanism of transfer between the two
I think we essentially said the same thing, but took different paths to get there.
And I'd argue that if you want to see how demand for puts impacts the price of equities you'd be much better off tracking option deltas than the VIX.
Does demand for equities impact the price of puts? No not really. I would love to see a study on that.
Correlation is not causation.
VIX goes down when SPY goes up because people are bullish. When you're bullish you buy equities and sell puts. When you buy equities SPY goes up, when you sell puts VIX goes down.
The strongly held correlation is that when people are bullish they do both of those things at the same time. You can't read more into that because the VIX is just a mechanical representation of implied volatility based on market makers models.
Not even true implied volatility, it's like 5 to 1 put implied volatility versus call volatility or something ridiculous like that. I haven't looked in a while to remember the exact ratio.
I feel like you'd have more success arguing from the point of treasuries versus equities because those have different demands for each that definitely could still result in causal relationships.
In fact, if you don't mind my saying that would be a really interesting topic. Though perhaps not something you prefer to write about. Just something that I'll probably go look for studies on now. So anyways, thanks for putting the idea in my head! I'm looking forward to your next piece.
I agree it sounds like we agree on alot but are coming to different conclusions. Does demand for equities impact the price of puts? Absolutely - to the extent that demand for equities change the price of equity, they also inherently change the price (and delta) of puts.
In any case, happy to have sparked some ideas from you and would look forward to read them if you ever decide to publish them. Cheers!