Buyside Strategies EQD Research Volatility
Jan 3, 2021
By Russell Rhoads, head of research
Something we have heard many times in 2020 is that the year was an outlier on many fronts, mostly caused by the Covid-19 pandemic that impacted all facets of life. Financial markets were not spared on both the operational end of things, with a dramatic shift to working remotely, to dealing with volatile financial asset price reactions to economic uncertainty associated with the pandemic.
VSTOXX is the best measure of expected volatility for European financial assets. In 2020, VSTOXX closed over 80 for the first time since the Great Financial Crisis (GFC) period of 2008 – 2009. The average closing price for VSTOXX in 2020 was 28.93, which is not the highest annual average on record, in fact it does not even qualify as the second highest annual average with 2008 and 2009 both averaging over 30. A surprising statistic is that in early 2020, there was a VSTOXX daily closing price only 0.01 above the all-time low. Specifically, on January 17, 2020 VSTOXX closed at 10.69, the second lowest closing price on record. A final statistic that stands out with regard to 2020, is the low to high range of 74.93 points, the widest range of the 21-year history for VSTOXX.
The price action in V-VSTOXX, a measure of expected VSTOXX price volatility also had quite a year in 2020. This measure did achieve an all-time high last year, but the history of this measure only goes back 11 years and does not incorporate the GFC period. The daily V-VSTOXX closing price averaged 109.34 in 2020. To put this in context the long term average for V-VSTOXX is 84.65 and the next highest average annual V-VSTOXX price was 93.53 in 2018.
Currently, VSTOXX and V-VSTOXX both remain a bit elevated, but some methods of interpreting VSTOXX, associated indices, and VSTOXX futures appear to signal lower volatility expectations as we enter 2021. Eurex publishes VSTOXX indices with a variety of time frames going out as far as 24 months. To get some perspective on the current levels of these indices we compared the VSTOXX term structure from the last day of 2018 and 2019 to that of the last trading day in 2020.
At the end of 2019 the spot VSTOXX index closed at 13.55. Going out farther in time, the index levels trend higher. The curve at the end of 2020 shows a bit of a dip from the six month to twelve month index. This forecast occurs after the index levels trend higher from one month to six months. It could be Euro Stoxx 50 option implied volatility currently prices in some concerns for the first half of 2021 and a less volatile forecast for the second half of the year. The curve at the end of 2018 is similar to the levels of the 2020 curve, but the shape is a bit different with expectations moving down the farther out in time on the curve. Bulls may hope that the similarity between the 2018 and 2020 curves holds up as 2019 was a pretty good year for the Euro Stoxx 50, rising about 25% and experiencing a steady uptrend the whole year.
Another useful method of interpreting market expectations involves comparing VSTOXX futures prices to the spot price. Again, we gathered data on the last trading day of 2018 and 2019 along with the end of 2020 to get some context on the current VSTOXX futures term structure. First, on the chart below, the 2019 VSTOXX term structure is displaying a normal contango shape, not really anticipating what was to come. By late February 2020 the VSTOXX futures term structure had moved into backwardation which preceded a quick 30% drop in the Euro Stoxx 50.
The 2018 and 2020 curves share some similarities in both level and shape. Both trend lower going out farther in time. The January contract is at a discount to spot on the 2020 curve, but was a premium to spot on the 2018 curve. The January versus spot index discount on the 2020 curve is a result of the Brexit deal getting done just before the holidays. When this was uncertain, both spot VSTOXX and the January 2020 contract were at higher levels.
With the VSTOXX indices and futures signaling a potential return to lower levels, I went searching for some late 2020 trades that appear to be anticipating lower volatility expectations and a lower VSTOXX in 2021. Both block trades I came across use the same structure, but have slightly different time frames and price forecasts.
The first was executed on December 23 and uses February VSTOXX options. With the February future trading at 23.70 there was a buyer of 3000 VSTOXX Feb 22 Puts for 2.225 who then sold 6000 VSTOXX Feb 20 Puts at 1.125 each resulting in a credit of 0.025 for each put spread. The payoff at February VSTOXX settlement shows up below.
One of the nice things about this trade is if the market experiences some sort of volatility event that pushes VSTOXX higher it still will make a small profit, based on the credit taken in when the trade was initiated. The goal for this trade should be a February settlement very close to the short strike price of 20. The trade makes more than the credit taken in between 18 and 22 with the real danger being a big move down in VSTOXX over the first few weeks of 2020.
A second trade was executed on December 29 and utilized the April VSTOXX option contracts. With the April VSTOXX future at 22.35 a trader purchased 1000 VSTOXX Apr 18 Puts for 1.10 and sold 2000 VSTOXX Apr 15 Puts for 0.25 each resulting in a cost of 0.60 per spread.
This trade is a bit more bearish than the first trade, but does have a wider range where it makes a profit at expiration. The trade loses the cost of 0.60 if April VSTOXX settlement is over 18. The range of profitability runs from 17.40 down to 12.60 with the best outcome resulting from an April VSTOXX settlement at 15. There is downside risk to the trade if VSTOXX experiences a large move to the downside in the first few months of 2021.
The coming year bring lots of hope for the world to return to some semblance of normalcy. As of the end of 2020, volatility expectations reflect this hope and outlook. VSTOXX, V-VSTOXX, and the related indices and futures will continue to adjust as time goes by and offer some early indication if there is a change in this outlook.