A “Non-Mathy” Discussion About Volatility, Variance, Correlation, and Much More

Mandy Xu, head of derivatives market intelligence at the Cboe, re-joins Interactive Brokers’ chief strategist, Steve Sosnick, for another wide-ranging discussion about a wide range of volatility-related topics.  They include, but are not limited to:

• Did low correlations imply that VIX was too high or too low?  
• How do correlation and dispersion relate to implied and historical volatility?  
• What are the upcoming Cboe Variance Futures designed to do?  

Summary – IBKR Podcasts Ep. 177

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Steve Sosnick 

Hi everybody. Welcome to the latest edition of IBKR Podcasts. I’m your host, Steve Sosnick, Chief Strategist here at Interactive Brokers. And my guest today for a return appearance is my friend, Mandy Xu, Head of Derivatives Market Intelligence at the Cboe. 

Welcome, Mandy. 

Mandy Xu 

Thanks for having me back. 

Steve Sosnick 

My pleasure. The last few discussions we’ve had were very well received and I hope people are looking forward to this as much as I am.  

Let’s jump right into things. Today we actually see, after a couple of days, that, VIX is flirting with 16. 

We’re taping this on Thursday the 18^th, and just to recap a little bit we’ve actually seen some of the major indices take a bit of a dive over the last couple of days and, what are just some of your general thoughts about just seeing, how we’ve jumped, call it, three, three and a half points in such a short period of time. 

Mandy Xu 

Yeah, sure. I think, given the context of the last couple months a VIX at 16. I don’t blame you for thinking it’s high, compared to this long-term average, we’re still very much in a low volatility regime. But in terms of the market action over the past couple days, what sticks out to me is, yes, we’ve had a pretty large pullback in terms of, 1%+ sell off in the S&P, 2% in the NASDAQ yesterday. 

But I still think this is a very much, idiosyncratically driven sell off in the sense that it’s a couple of large megacap tech names that are really dragging the market down rather than a broad sell off, right? So even on a day like yesterday, if you actually looked at the breakdown like the sector breakdown that half the sectors were up half the sectors were down. So, it was still a very low correlation, low volatility, high dispersion environment, even on a market down day. 

And it was really on the back of some of the geopolitical news, which obviously, that hit the chip makers much more. But still I think just looking at the spot move in the index, you might think that it was a very material risk off move, but if you look underneath the index surface, I would argue it was really just a couple of mega cap stocks versus still everyone else. 

Steve Sosnick

Thank you for recapping the piece I just posted online. Literally my point. I’m trying to make the term “routation” stick because to me that’s how I’m defining it.  

Because we’ve gotten so crowded in the mega cap tech trades, I’ve been one of the people advocating for a bit of rotation just to take some of the steam off of the pressure valve, as it were, that we without having had a correction for so long. 

The problem is we’ve gotten so concentrated. You can’t have a decent sell off in those stocks without dragging the indices lower. Even if, as you noted, the actual underlying market was rather mixed. And you led into the point that I was hoping to really touch on with you because our first discussion really delved into this and we’ve it’s been a popular one both with listeners and readers ever since. 

And that is the correlation, at least as measured by the CBOE COR1 and 3M indices, has been extraordinarily low. As of earlier this week or late last week, it hit a, pretty much an all-time low on both those indices. Meanwhile, DSPX, the dispersion index — which is, similar, but not the same because the COR1M measures the correlations within the top 50 stocks — and the dispersion index is a bit broader. That’s not necessarily at all-time highs, but it’s flirting with post-COVID highs. So, if you could really delve into that a little bit more, because that was, my argument had been that even though VIX was in the mid-twelves, considering the correlation, considering the dispersion, it actually was showing a fair amount of risk aversion. 

It wasn’t showing the type of complacency that the low level itself might have indicated. I’d love to get your thoughts on that. 

Mandy Xu 

I love that you’re using the COR1M, 3M indices and the DSPX, the dispersion indices as signals because exactly that’s why we designed those indices and it’s really meant to give you a more complete picture around what is going on in volatility markets, not just what’s going on at the index level, but really underneath the index surface. 

So, I’m so happy to hear you say that.  And to your point, implied correlation levels have gotten to all-time lows, and it’s actually pretty incredible. If you look at COR1M, as you alluded to, hit an all-time low of 2% last week, 2%. It’s mind boggling. The long-term average for that index is about 40%. 

And even in 2017 when the VIX hit 9, that index was, hovering around 8 or 9%. So, we’re well below the kind of levels that we saw in 2017 in terms of correlation.  And then, related to correlation, not exactly the same, but it’s the concept of dispersion, which really just measures how much stocks are moving relative to each other. 

And we came out with the DSPX index late last year to give you a better sense of kind of stock volatility. And that, as you mentioned, it’s at a post COVID high. And actually, if you back out from the DSPX the weighted average single stock volatility, the difference between that versus index vol is currently actually at an all-time high. 

So VIX, in the mid-teens, low teens, single stock vol in the 30s that spread over 20 points is at an all-time high. So that kind of tells you that even though the index level is not moving a lot, there’s a lot of movement at the single stock level, and we can talk about why that is. 

It’s not a new phenomenon. This whole high dispersion, low correlation, we’ve been seeing for most of the past year, and I would say it’s on the back of a couple of factors. So first, obviously, is the rate environment, the inflation environment, the way that people have been playing, changes in expectations of interest rates and inflation. 

It’s been through sector and stock selection which are the most sensitive, rate sensitive names, which are the most inflation sensitive names. And then going long and short those, it’s on the back of, the secular themes like AI. Obviously, we’ve seen some very outsized moves in a lot of the AI names. 

It’s on the back of earnings and the focus on earnings and where we are in the economic cycle. And we’ve seen some pretty outsized moves on earnings. These are like, what I would consider healthy reasons, healthy drivers for the market. They are fundamental, they’re idiosyncratic and they’re not,macro, right? 

And because different sectors and different stocks are being driven by different factors, the correlation levels is all time low. So, when you aggregate these moves to the index level there are days when the index really doesn’t move at all, right? And you touched upon, the complacency or the lack of complacency. 

The realized volatility in the market, if we just look at how the S&P index itself has done that realized vol hit a given the fact that the index itself is now moving, VIX in the teens still when realized vol is at 5 that shows there’s still a healthy risk premium being embedded in the derivatives market. 

Steve Sosnick 

I did point that out at the time as well, because the spread between implied volatility of at money SPX options, vis a vis the historical, I use 20-day historical, was again at one of the biggest spreads we’ve seen in quite some time. These are all playing in. 

That was my assertion again, because if that spread had been maintained, it would be logical to think of VIX around single digits, and we just didn’t get there. 

Now, expanding it a little bit, we saw a 10% move in Russell 2000, IWM, in about five-day period through Tuesday of this week.  What are some of your takes on that? Because I know you’ve done some work on, looking at anomalies, let’s say in IWM and pricing and the like.  

Mandy Xu 

Sure. In the Russell 2000, either at the index level or the ETF level, we’ve seen a huge pickup in terms of upside call buying. It’s a little bit of a deja vu, because we saw this exact same phenomenon in Q4 of last year going into the beginning of the year, and the driver was very much similar in that it was expectations of Fed easing, people started pricing in more said rate cuts investors started really piling into small caps, which tend to be or to consider, beneficiaries of lower rates and obviously that time it didn’t really play out as we saw a big unwind of that easing move for most of this year up until now.  

But to give you a sense of how big that rotation has been, so last Thursday on the back of that CPI, softer than expected CPI number, we had actually the fourth largest single day outperformance of small caps over large caps. So, I think, Russell was up maybe 3.5%, S&P was down almost 1%. 

That’s the largest single day outperformance after 1987, Black Monday, after 2008 October, Global Financial Crisis, and March of 2020 during COVID. So, these are pretty, pretty incredible stats when you think about it. And then the options market, what we’ve seen is a huge increase in Russell implied volatility. 

So, if you look at our RVX, index, which is the VIX for the Russell 2000 index. The difference between that versus the VIX has exploded, right? So, the difference between the two indices hit over 11 points earlier this week. That’s a one year high, so even higher than what we saw in Q4. That kind of gives you a sense of kind of the option buying demand that we’re seeing in Russell, and that really is coming from the call side. 

So, another metric that we follow closely, which is skew in Russell options, so measuring demand for puts versus calls.  As many people know, index skew typically tends to be positive, right? So, more demand for puts, more demand for hedging, then there’s demand for upside. So last week going into this week, we actually started to see skew invert in Russell, meaning actually calls trading with higher implied volatilities than puts, or calls being more expensive than puts, of equivalent strikes which is extremely rare. 

Before this episode, and before Q4 last year, You’d have to go all the way back to May of 2005, so almost 20 years, before you got a similar episode of inversion in Russell skew. And then as far as we have data for, it has never happened in the S&P and the Large Cap Index. These are some pretty abnormal moves that we’re seeing in the options market. 

And I really think a big part of it is people are appreciating it. Preferring to play this rotation using options rather than adjusting a portfolio, selling their large caps and going, piling into small caps en masse because of what happened in Q4, because of still the uncertain macro picture, they prefer buying call options where, you know, if you’re wrong, you’re out the premium paid, but that’s a very small percentage of the overall if you had to buy the stock, the underlying index. 

Steve Sosnick

You hit on some really important points there. First of all, of course, is the idea, I think, that people have gravitated toward options. I think people have really become to get much more in sync with the idea of the limited cash outlay and the leveraged return. I do think some of that came from people who started in sports gambling, but we’ll take that another time. And I know that that from the Cboe, that’s not something you want to discuss. And I have a feeling my compliance people here are going to have a little conniption about that, but the logic is the same: a cash outlay and a potentially leveraged return.  

But also, as you point out that RVX uses the VIX methodology and that it exploded, that to me is one of the prima facie examples of the idea that VIX is not a fear gauge, but it plays one on TV.  It, because it does respond to factors other than fear. Yes, perceptions about the volatility over the coming 30 days tend to be correlated with fears about volatility, but it also, as you mentioned with RVX, it’s just responding to the fact that there’s this huge demand for calls. 

It is easier to buy a call option on IWM or the Russell index than it is to go en masse in an index where the total market cap is about that of Apple. And so that is a very important takeaway is that if you look at it and say, the RVX exploded, the Russell VIX exploded, it did, but for the right reasons, because it wasn’t fear, You could argue it was excessive greed and not fear. 

Mandy Xu 

Absolutely.  It’s really important to highlight that volatility can come from the upside as well as the downside. And I think generally people associate volatility with downside moves, but I think especially in an environment where we’ve been over the past 18 months, two years, it’s really important to talk about the upside volatility because that’s actually been the volatility that’s been most painful for a lot of institutional investors who, came into 2023 last year very bearish, everyone was expecting a recession, expecting a pullback in stocks.  And instead, we got a 20%+ rally in the market and people being underexposed to that and then having to chase the rally or hedge that right tail risk using buy, using upside call options, right? 

That’s a great example of that and one of the things that we’ve been highlighting it’s just if you look at how the S&P has behaved over the past year, what has been really unusual and what I think really interesting is that we’ve seen actually more realized volatility on the upside than the downside. 

So, market up days have been more violent and bigger in magnitude than market down days, right? Which is the exact opposite of the historical pattern or the typical pattern where, people talk about markets take the escalator up and the elevator down, right? It’s the most violent moves tend to be to the downside, but over the past year or two years it’s been the opposite. 

The violent moves have come from the upside and that if you think about, trading options as a way of managing risk, then it makes sense that we’re seeing all this activity and the interest in the upside calls because that’s been where the volatility has been and where, people needed to manage their risk and manage their exposure. 

Steve Sosnick 

I did happen to run those numbers earlier this week and through yesterday we’d had 15 up days greater than 1% and yesterday was the eighth down day of greater than 1%. And going back over the course to the beginning of 2023, which actually I believe was the last 2% down day, it’s been again more two, two to one, although we did have a couple more downswings at various points in fall of 2023.  

I think so much of what we’ve been driven by, I called it weaponized FOMO. Whereas institutional investors had to get in there and they have to get in hard. With individuals I caution them against FOMO, we all get it from watching our friends do cool things on Facebook and Instagram, but you don’t have to do it in the markets if you don’t want to. But if you’re an institutional investor, it’s your career risk, and as you point out, that’s the simplest way, you may not have wanted to pay whatever the going rate was for NVIDIA, but if you wanted those returns, you could buy calls and get them, and pick your benchmark and you could do the same thing. 

And also, you hit upon my favorite point, which I like to call socially acceptable volatility. And that is volatility is agnostic. It moves up, it moves down. It’s standard deviation. It doesn’t care whether it’s up or down. People care whether it’s up or down.   

For the same reason that I’m sure you’re like me and you get many more calls on a down day than you do on an up day.  Think about it, you go up 1% okay, it’s supposed to go up, it goes down 1%, what went wrong? And I do think that we all do this in the market, and I didn’t coin the term socially acceptable volatility, my friend Steve Sears did, but I’ve latched onto it… 

Mandy Xu 

I love that. 

Steve Sosnick 

I’ve been like a barnacle on that one, because that to me is my, one of the best ways of explaining it. 

Now, going forward, when we were talking back and forth in some of our notes, you’d mentioned that the Cboe has some exciting products based on variance. Since I mentioned standard deviation, I might as well bring in its older brother, variance. And please explain the concept of variance and the type of products that the CBO will be introducing for investors to get exposure to or hedge against variance. 

Mandy Xu 

Yeah, sure. So, we are bringing Variance Futures to the market. Expected launch date in September. And what that is just another way to trade volatility, but different from the existing products out in the market. So, you think about the easiest way people currently trade volatility, whether it’s VIX Futures, VIX Options. 

Those are very much Instruments that allow you to take a view on where implied volatility is going to be in the future, right? Where’s the VIX going to be in the future? And you either do it through futures or options but it’s very difficult currently if you want to have a very easy way to capture the difference between implied and realized volatility and we touched upon that, right? 

So VIX at 12 and VIX at 13 may be low, but it’s not cheap because it’s realizing if you’re someone who is trying to capture that implied to realized spread, it’s realizing at, five or six.  

So, there’s a very juicy spread out there. So, if you want to sell implied vol and capture that implied to realized spread, you can do it currently in the listed option space. 

It involves daily delta hedging your position to get rid of the delta risk to give you just the vol exposure. But I would say for most people that, it there is no logistical component to that in terms of delta hedging and sophistication regarded regarding that. 

So, what we’re doing with Variance Futures is bringing to the listed market historically a OTC over the counter instrument that allows you to explicitly capture the difference between implied to realized. For example, if you want to buy variance at 23 and it comes in at 20, you capture that difference of 3. 

Or if you sell variance at 23 and realize it’s at 20, you make a profit of 3 vol points. So that gives you a explicit way to monetize that implied to realized spread which is just another risk premium for option traders to capture and to look at. 

So we’re very excited about that product coming to the market.  

And I would say that, for those of you who maybe have been in the market long enough, you’ll know that this is not the first time we actually try to bring variance futures to the market. We’ve done it twice before and what really has changed this time is, A) regulatory capital requirements of trading OTC has gotten more onerous, so a lot of actually banks and as well as buy-side customers, institutional customers, have actually come into us saying that we need to, like they would like to have a listed counterpart to it. 

So, I think that’s, the environment has changed such that I think, right now is, a good time or the right time to be bringing a listed product to the market. So, we’re very excited. I’m sure we’ll be interesting, a volatility catalyst for the market. 

Steve Sosnick 

Actually, your timing of a potential September launch date is very auspicious, considering the bump that we have in October VIX futures right now.  

I’ve explained it, but I’d like to hear your take on it. I think I, why just because it’s important for people to understand, because also actually today, someone just reached out to me and said, Oh, Aug 12 calls in VIX are trading below intrinsic. 

No, they’re not because they trade off the futures, not off the spot and there’s backwardation. 

I think we’ve discussed this before, but please just explain the little bit about how the futures work and why we see, sometimes backwardation and as opposed to the usual contango and why we’re seeing a bump in October. 

Mandy Xu 

Yeah, sure. So VIX futures term structure or the curve typically is upward sloping, right? And that’s because if you think about volatility or imply volatility as a measure of uncertainty, the way I like to explain is that you’re, if I asked you where’s the S&P going to be, a week from now your guess is probably, up or down 1% from today, right? 

It’s a very narrow band in which we can trade. If I ask you, where is the S&P going to be, a year from now? Then the uncertainty band is a lot wider, so there’s just more uncertainty the further out you go in time, which is why typically the volatility curve, the term structure, is upward sloping, and that is exactly what the VIX futures curve is reflecting. 

It’s expectations of volatility at different points in time. And that’s what we typically call upward sloping or contango. Now it can become inverted or backwardated when there’s actually a lot more near-term stress. So, you see this during the big market sell offs, right? For example, the extreme example recently has been, obviously COVID. 

In March of 2020, VIX spot was at 80. Front month futures was at 70. But if you go further out, like if you were looking at the year-end future back in 2020, it was trading around 30, even in March, right? The reason for that was, because COVID at the time was a new virus, people didn’t know what was going on. What was the infection rate? What’s going to be the government response? 

So, there was just a ton of near-term fear, near term stress, but, like going out a year, people, I think expect volatility to start to normalize. It is a mean reverting asset class, right? So, they don’t know exactly what things are going to look like a year from now, but they know it’s not going to be as acute as what we saw in March of 2020 when COVID first hit, right? 

So that’s an example where you can have a backwardated or inverted futures curve.  

Now, in between these two, you can also get interesting kinks in the curve. So that’s what we’re seeing right now. So generally, an upper sloping volatility curve but we are seeing a pronounced kink around the October VIX future and by that the October VIX future is trading above both the September as well as the November VIX future. 

And that’s really because of the election. Now one question I get is why is it being reflected in the October VIX future and not the November?  

And keep in mind that the October VIX future is going to expire into VIX spot, right? When VIX spot is a forward looking 30 days. So, at expiration, it’s going to reflect what the volatility is going to be for the next 30 days from October to November. So that’s actually the futures contract that’s going to capture the expected volatility around the election. So that’s a little bit of a nuance to the product but in terms of the election risk premium, what I find interesting is that since the start of the year, we’ve seen a very persistent, about a two to three vol point premium to the October future compared to say the September. 

And that really hasn’t changed even in recent days despite all the political headlines about how the race is over, and obviously, there’s been a lot going on in the political sphere. I would say despite what the pundits may think, despite what the headlines may suggest, in the market there’s still a very sticky risk premium being priced in for the election. 

Steve Sosnick 

Yeah, that actually was one of my tells this week because a lot of people said, “Oh, what is the market telling?” And it’s you know what, the VIX, that bump in the VIX futures curve hasn’t changed. My other tell was, involved. The steepness of the yield curve, which also didn’t move appreciably.  So, I think it does tell us that the market’s still, maybe not as certain as some of the pundits will claim about the election.  

The other thing, and we’re running out of time, so just going to give you the quick one. One of my other reasons why, while I’ll assert that we get into backwardation, is because this applies to me as far as any futures product goes, is a lot of times when you have that backwardation, it reflects an imbalance in the short term demand vis a vis the short term supply, meaning that there’s just more demand than the market is willing or able to provide in the short term, whether that’s volatility protection or pork bellies it’s just going to be the way it reacts. 

And so, one of my premises at some level is that VIX it’s not a fear gauge, it plays one on TV and we went back and forth about that it’s the calculations and stuff like that. But at some level, do you agree with my assertion that at some level it really reflects the level of the VIX, particularly vis a vis the historical, is somewhat of a barometer for institutional demand for volatility protection, and might that play into the variance contracts that you’re going to be launching? 

Mandy Xu 

Yep, no, absolutely. I would say it definitely reflects imbalances in supply and demand, and we saw that, for example, in Volmageddon in Feb of ’18, and obviously also in March of 2020, where a lot of the short vol strategies, were forced to unwind and had to get stopped out and that kind of exacerbates any kind of moves in the front of the curve. 

Absolutely, I would say that can happen. Like in Feb 18, for example, you have that Explosion in implied vol, but not really in realized, so that would have been a good time if you were able to look at selling variance in the market. 

Of course, that was also a time where, you know, being short of vol in general and the margin calls and things like that, around that trade was particularly onerous, But certainly, to your point, you can have dislocations and implied volatility without a follow through and realized volatility, in which case it sets up well to monetize using an instrument like Variance Futures or Variance Swaps in the OTC market where you can really play that difference between the two. 

Or in the case of March 2020, actually it was a case of both implied and realized exploding higher, right? So, people talk about VIX at 80, being very high, but keep in mind in March of 2020, S&P was having daily moves of 10%.  

So realized vol was even higher. That was a case where actually both were going up and both were going up for a very good reason of, those new viruses, new pandemic that was hitting the globe at the time. 

Steve Sosnick 

Mandy, this is like the fastest half hour when we have, at least I find it that way when we have our discussions because I think we’ve basically we’ve hit a lot of topics. I have a long list of things we didn’t hit, but I guess that gives us more to talk about next time and I hope there will be a next time. 

But I want to thank you so much for joining me today. It was a real pleasure. 

Mandy Xu 

Thanks for having me on. Always a pleasure. 

Steve Sosnick 

And thank you to all the listeners. You’ve been listening to IBKR podcasts. As I mentioned earlier, my guest today was Mandy Xu, Head of Derivatives Market Intelligence at the Cboe. And thank you all for listening. 

I hope to catch up with you all sometime soon. Take care, everybody. Bye bye. 

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