Increasing Volatility in the Options Market

Series Introduction

This paper is part of an ongoing series from BlackIV, wherein we share our analysis of the options market, and how to develop a successful option trading strategy.

For sophisticated traders and institutions, options provide an important tool for diversifying a portfolio, or hedging a portfolio against certain risks. For the speculator, there is the opportunity to see massive gains on a relatively small position. These gains carry substantial risk, as it is commonly said that 80% of all options expire worthless, leaving the long option holders in the red on a majority of their trades. Option sellers are not without risk, however, for when a trade goes against them they need to pay out many times the initial premium they received. This commonly wipes out all gains from multiple successful sell positions, and returns the trader to square one. To prevent these scenarios, it’s important to understand the risks of these types of trades and to define a consistent trading strategy, backtest it, and be diligent in its execution. It is also critical to understand the options market as a whole, and the forces that influence it, in the same way that equity traders analyze industry trends for the stocks in which they invest, as well as the broader economy.

Given the amount of information present in the options market (multiple strikes and expirations for each security), the complexity of calculating the fair value of an option, and projecting the change in value of these options under different circumstances, this analysis can become quickly become onerous and overwhelming. All of this does not take into consideration industry analysis, or the broader economic analysis, that is also required for any successful trading strategy.

At BlackIV, we focus on the options market, and are constantly analyzing it for anomalies that can indicate a new trading signal, or a change in a long term trend. That process involves determining what “normal” is, which in and of itself is fraught with difficulty. Throughout this series, we will use a range of analysis to paint a clearer picture of the otherwise convoluted and opaque options market.

A Note on Prior Knowledge

In this series, we will assume that the reader is familiar with the general definitions of options and the more common associated terms, such as long vs short, puts vs calls, out-of-the-money (OTM) vs in-the-money (ITM), the different types of trades that can be placed (e.g. covered calls, naked puts, spreads, etc.), and their payouts. While this information is very important, if you’ve found yourself reading this paper, you likely already know these terms.

Theory versus Reality

Much of the above mentioned prior knowledge deals with the theory of options and their payout structures, and these calculations are straightforward at expiration. A common example: If you buy an OTM call option at a given strike, the value of the option will increase if the underlying price moves above the strike price. If it moves above the strike price PLUS however much you paid for the option, the position is positive.

It is the price prior to expiration, based on the risk of holding the option, where anomalies become apparent. When options were first introduced on the Chicago Board Options Exchange (CBOE), and the Black-Scholes model developed to provide a foundation for pricing them, the assumption was made that stock prices moved based on Brownian Motion, or random walk. If this theory was correct, all price changes could be fit to a normal distribution, but this is not the case. It is far more likely to see large moves, “black swan” events, than are theorized by the model. This was first widely accepted after the stock market crash of 1987, when the stock market moved more quickly than anticipated by a random walk.

To account for this, the price of both OTM and ITM options has increased over time. This can be seen in a graph of implied volatility for a given stock and given expiration date. The below chart from 7-14-2023 shows the Volatility Smile for SPY OTM options (vertical line is the underlying price, left side are OTM puts, right side are OTM calls), expiring on 7-28-2023. According to the Black Scholes model, this line should be flat, but it is not, and that is to account for the increased risk of a tail-event.

**Chart generated using data from CBOE**

A Deeper Dive into the Data

This trend towards increasing volatility has continued, especially in the past decade. Separately, two recent market crashes, the pandemic crash in March 2020 and volmageddon in February 2018, resulted in options being priced ever higher to account for the increased risk of writing them.

The below graph shows the increase in options prices (calculated at the mid point between the bid and ask prices) for call options at delta=0.25, with ~45 days to expiration, over the past 13 years. Prior to Volmageddon, the average price of these options was $10. Following volmageddon, that number rarely fell below $15, and following the pandemic crash it hasn’t fallen below $20.

**Chart generated using data from CBOE**

Why would those on the other side of these trades be willing to pay the higher premiums? The answer can be seen in the value of these same options as we move towards expiration. The below graph shows that more of these options end up positive after 30 days, and when they are positive, they reach a higher dollar value.

On the bottom half of the graph, the increased premiums result in lower negative values for those options that do not go into the money.

**Chart generated using data from CBOE**

The final result can be observed in the linear fit line. There is a very slight positive trend over the 13 years, but on average, the increased premiums offset the increased price of the options that do go into the money.

One final graph shows the significance of volmageddon compared to the pandemic crash. In dollar terms, the pandemic crash was more significant, but if you were holding OTM options prior to volmageddon, it was a far more profitable trade in percentage terms. In this dataset, it is clear that volmageddon was the event that initiated the increased prices of options, and the post-volmageddon period appears equivalent to before on a percentage basis.

**Chart generated using data from CBOE**

Here are a few more charts to visualize this data. First, the minimum and maximum value of these options during each year. This also shows the general trend that the magnitude of the option’s value is increasing.

**Chart generated using data from CBOE**

Finally, the average value of all options in each year. Given that the conventional wisdom is that long options are generally unprofitable, it is remarkable to see that, in some recent years, long volatility was a successful strategy:

**Chart generated using data from CBOE**

Looking Forward

What is causing these trends, and more broadly, what is causing volatility to increase? To use the above data as part of a trading strategy, and to better understand the market as a whole, this is the question we need to answer. From there, we can make predictions on future behavior. The question of volatility increasing is a thoroughly debated and researched question, so because there is no definitive answer, this section will be conjecture.

As we are examining the SP500, our analysis needs to include the global economy and worldwide trends. The below list is by no means exhaustive, but represents those trends for which there is a clear history, a consensus that the original status quo has changed, and there are clear and measurable effects on the economy:

1. Over the past 13 years, we’ve had nearly 0% interest rates and ongoing quantitative easing in nearly all major economies around the world. “Free” money, as it were. That has now changed with the onset of significant inflation.

2. Globalization reached its peak of efficiency and inter-connectivity in 2019, and will arguably never returned to those prior levels. The shortages of the pandemic let everyone see just how vulnerable international supply chains are, and coupled with rising populism, we’re now in a period of on-shoring and near-shoring of those same supply chains.

3. The world’s populations are growing older, and in some cases retiring, meaning there are fewer young workers and consumers. Because consumption is the main driver of economies, we can expect there will be slower growth going forward, with no growth in some countries.

4. The return of war in Europe.

All of these trends led to global stability and growth over the last 75 years and, based on the evidence of the past several years, it is hard to argue that they have not all reversed. Any one of these could cause an increase in volatility, but we are seeing them all occur at once. Each of these is a novel in and of itself, but again, it is reasonably self evident that these trends have reversed, and there is no sign of things going back to the way they were.

The effects of these trends reversing will have wide-spread and sometimes difficult to predict ramifications. Some countries, industries, and companies will benefit from the above. If we do see an increase in black swan events, we can expect them to be priced into the market as we saw volmageddon and the pandemic crash priced in. To anticipate these events, and thereby profit on them, specific knowledge of each area is required to know what kinds of trades to place, and what companies to invest in.

The Rise of Passive Investing

There is another factor I want to mention at this point, one that has a more mechanical effect on the behavior of stock markets. According to Bloomberg, the amount of money invested in Passive funds is now greater than the amount invested in Active funds. This 50% threshold is psychologically significant, and it has an increasing effect on the market.

Source

The below example shows a part of the stock market. The close price of SPY on 7-21-2023 was $452.18, so we will use that as a starting point, with some randomly generated data to fill out the rest of the order book. In the first chart, we can see the order book of Bids and Asks on SPY. The second chart shows the effects of a buy order of 200 shares entering the market, and the resulting price. In this example, a buy order of 200 shares leads to a price increase of $0.05.

**Simulated order book**

The order book, the ledger above, is populated by Active investors. Active investors trade based on value, or some other form of analysis. There is a fair price that they calculate, and they place orders in the ledger to be filled when there is someone available on the other end of the trade. That is the order book that you see above, a list of prices that traders are willing to buy and sell at, but have not yet been filled.

Passive investors do not place entries into the ledger. They buy or sell at whatever price they can get. The Passive investors are typically workers with 401Ks or other investment vehicles that regularly buy into the market. They are price insensitive, and buy every 2 weeks or so, because that is the most common advice given to those saving for retirement: buy and hold, and do not sell under any circumstances because the market will always come back and it’s extremely difficult to time so don’t try it. All of those points are true, and it leads to a group of buyers in the market who are ever present, and always push the market a bit higher.

The effect of Passive investing is to remove entries in the order book. Below is an updated example, with half of the entries removed. A buy order of 200 shares now moves the price up $0.08, an increase of 60%.

**Simulated order book**

This example is only for one trade. We can expect that any market movement we would have seen in years past will be amplified, and that is strictly due to this shallower order book, and the ability of buy and sell orders to move the underlying price further in either direction.

Conclusion

Since options were first introduced in 1973, we have seen them adjusted in price to account for the possibility of tail events that cause massive price swings. More recently, with the rise of passive investing and the reversal of globalization, these increased premiums are increasingly justified. We anticipate that volatility will continue to increase, and that there will be opportunities in the future to profit off of tail events that are not priced into the market at present.

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