Volatility ETF mop up VIX

As readers of this column are well aware, we have been puzzled for many months about the structurally-lower volatility in equity markets.

This is all the more surprising in that we have seen single stock volatility (realized) increase, notably in Europe. Readers versed in options know that implied volatility and realized volatility don’t necessarily go hand in hand, nevertheless, such a decorrelation has been puzzling to many. 

Interestingly, a potential explanation was provided in an article published by the FT on March 20.

Unsurprisingly, once again the guilty party is the ETF industry through the “options based ETFs” and especially those with a call overwriting strategy. 

The mechanism of call overwriting is simple: it entails holding an underlying security while also writing a call (usually out of the money) on it. With the premium collected, the fund can enhance its performance (provided the stock isn’t above the strike price at expiration). 

Why does this strategy have an impact on volatility? The strategy of the fund is to buy a stock and to sell a call out of the money in the market. Because it is long of the underlying, it doesn’t hedge its position. With a lot more options being structurally put on the bid, the price of the option goes down. Of course, because all other things being equal, the price of the option is linked to the implied volatility, the drop in price is considered a drop in implied volatility. 

On the other end of the trade, the buyer of the option will hedge their delta position. Unlike the selling party, this is generating some gamma. As the buyer is gamma positive (being long of the option) he will have to sell more of the underlying when it goes up, and will buy more when the underlying goes down. This also means that the realized volatility goes down overall. 

Of course, this mechanism would have little impact on the market if ETFs made of listed options were marginal. But according to JP Morgan, over the last three years, the total AUM of US listed option ETFs has been multiplied by 8 to reach around USD100bn and 70% or so of these were call overwriting ETFs. This is more than enough to crash the volatility, both implied and realized. 

If this technical explanation is correct (and we have no reason to believe it isn’t), it implies that Mom & Pop volatility indices are no longer functioning as a measure of the market nervosity. Indeed, it no longer mostly reflects the appetite to hedge against a potential drop but incorporates above complex hedging strategies that bear no connection with market risk perception. 

Actually, one could even argue that a call overwriting strategy necessarily implies that the short-term potential of the underlying is limited. Indeed, why would one sell a call if one believes that the market is set to go above its strike at expiry? Add to the above thinking line the downward pressure exercised by same day options still a novelty where punters tend to go ‘long the wings’ in the risk distribution thereby presumably capping implied volatility as well.

Single stock volatility could be a better measure of the risk on a specific stock. Yet here again, and for the exact same reason, the implied volatility will not necessarily reflect the degree of protection sought by investors, especially for the most liquid stocks where options are readily available.

Paradoxically, the side effect of the development of these ETFs could be that good old fundamental analysis will be back in fashion. Indeed, if the perception of the risk of a given stock or index can no longer be provided by external quantifiable factors, one will need to rely on the human expertise of market participants.