Episode #279: Kevin Davitt and John Hiatt, Cboe, “Relative To The Overall Portfolio, Small Allocations To Tail Risk Ideas Can Have An Outsized Impact”

Episode #279: Kevin Davitt and John Hiatt, Cboe, “Relative To The Overall Portfolio, Small Allocations To Tail Risk Ideas Can Have An Outsized Impact”







Guests: Kevin Davitt is the Senior Options Institute Instructor for the Cboe, where he has led the Cboe’s global derivatives education by teaching more than 30,000 students since 2015. As a former options market maker on the Cboe and PHLX, Kevin is recognized as a trusted source for education and market intelligence globally.

John Hiatt is the Vice President of Derivatives Strategy for the Cboe, where he develops indices and tradeable derivatives products for Cboe Global Markets. Most notably, John and his colleagues paved the way for volatility to become recognized as a tradeable asset through the development of the Cboe Volatility Index (VIX), as well as VIX futures and VIX options.

Date Recorded: 12/2/2020     |     Run-Time: 1:07:24

Summary: In today’s episode, we’re talking about options, the VIX, and tail risk strategies. 2020 saw elevated volatility and record levels of option volume, and Kevin and John give us their perspective on this activity. We start with some basics of the VIX, how investors use and misuse it, and what the VIX says about the market over time. Then we get into tail risk strategies. We cover how investors should implement them, how to evaluate their success, and how these strategies can have an outsized impact on your portfolio.

As we wind down, Kevin and John discuss ways to implement these types of strategies in a portfolio and best practices to communicate these strategies with your clients.

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Transcript of Episode 279:

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Meb: Howdy, howdy, friends, great show. We have two phenomenal guests today from CBOE. One is the Senior Options Institute Instructor and the other is the VP of Derivatives. In today’s episode, we’re talking about options, the VIX, tail risk strategies. 2020 has seen elevated volatility and record levels of option volume, and our guests give us their perspective on this crazy year.

We start with some basics of all on the VIX, how investors use and misuse it, and what the VIX says about the market over time. And then, we get into tail risk strategies. As we wind down, we discuss ways to implement these types of strategies in a portfolio and best practices to communicate these strategies with your clients. Please enjoy this episode with CBOE’s Kevin Davitt and John Hiatt. John and Kevin, welcome to the show.

Kevin: Great to be here and thanks for having us.

John: Yes, thank you for having us, excited to talk to you.

Meb: I thought we’d start with something that required some pronunciation inquiries. My wife was a Philosophy PhD and my super power is mispronouncing things. And so, I said, “How do you pronounce this? Heraclitus?” That’s eventually what I settled on after nine different mispronunciations. She’s like, “You don’t know who that is?” I said, “No.” She said, “Well, he’s ancient Greek philosopher.” I said, “Well, that’s interesting.” Because I was reading this called “Inside Volatility Trading: So Now What?” And the intro was on Heraclitus. Reminded me of the old Bill and Ted, they’re talking about Silk Trades. Who wrote this one? This is Kevin.

Kevin: That was me. And, man, your wife, a classics type, I’m already a little bit nervous about this. But that is something that I write typically twice a month. We try to take a look at volatility from a really broad perspective. And that probably gives you some sense that I try to weave in things like ancient philosophy, a bit of music. And I believe the bent there was, he was one of the early process philosophers and this overall belief that change is one of very few constants. And I think that’s a concept that can play a really important role in understanding markets and being comfortable with the existence, the fact that volatility, broadly speaking, is a constant. And so that became a lead in to one of the recent write-ups. I appreciate your pointing it out.

Meb: It’s an interesting topic. I mean, especially given 2020 because I often tell people, I say, “Look, 2020 shouldn’t necessarily be teaching you any new lessons, but rather be a reminder of old lessons, one of which is that the future is uncertain.” We had a tweet that said most investors probably be better suited to be less Nostradamus and more Rip Van Winkle, meaning that everyone wants to predict the future but no matter what we can count on, one thing in particular is that it will surprise us. And so, the example of this year, the U.S. stock market going from an all-time high to bear market, and round-trip fast as ever. But that’s to be expected, you know, in using history’s guide.

Okay, philosophy, we could spend all the time on this. Talk to me a little bit about volatility, guys. You guys are pretty famous for understanding all things fall, and getting to all the Greeks, and skews, and everything else. But let’s just start with the basics. What does volatility mean, you guys? Does it mean the VIX? Does it mean something else? How do you all approach it?

Kevin: Maybe I’ll take a first stab at that. And I think that John would be able to elaborate a great deal. But from, like I mentioned, a really broad perspective, I think that the word itself often has a negative connotation. In everyday use, you don’t go out and like wake up and think, “I hope to introduce some volatility to my day,” right? There’s a negative sort of embedded connotation with that.

But in capital markets, it’s simply a way to quantify rates of change. And so, from a derivative standpoint, you’re talking about figuring out what the standard deviations of asset changes are over a given timeframe. And that, in and of itself, is valuable.

So, over the past 20 years, which encompasses my time in this business, it’s been fascinating to see the evolution of volatility in the markets going from something, and this is just my perspective, but where the handful of niche option or derivative types would talk about volatility or talk about the idea of the VIX and to see that evolve into talk about volatility as an asset class, and we could go back and forth as to the legitimacy there or how that’s interpreted, but to see that there is now tradable product and there’s been a proliferation of it, which John played a hugely instrumental role in that evolution, from a basic standpoint, we’re talking about the rate of change, which, as we mentioned at the outset, change is a constant. And so, from just a pure math standpoint, it’s something that we can put a number to and then compare that to different times in the past. John, what’s your take?

John: Yeah, I suppose that I could probably point to the day when my views on volatility and measuring volatility actually started. I started at CBOE in the market regulation department and got a job in research and product development in 1997. And the first thing they did was send me to a conference that was hosted by the International Association of Financial Engineers. And there was a fellow there by the name of Peter Carr that gave a talk on replicating the variance of the S&P 500 through a portfolio of options.

And the idea that you could hold a portfolio of options and the underlying, and replicate the statistical property of the return of the S&P 500 was kind of eye opening to me. That wound up being the first project that I worked on within product development was the idea of, could we create a listed derivative that settled to a measure of volatility?

And we actually wound up kind of using some of the stuff that Peter Carr had done to change the way that we calculated the VIX index, which was our metric of measuring the volatility of the equity market in the U.S. It started being an implied volatility measure. By implied volatility, I mean, we used an option pricing formula and at the money options on the S&P 100 Index, which was the big options contract at CBOE at the time, and we backed out a volatility that was implied by an option price. And that was what we reported as the VIX.

And then, in 2003, we actually reworked the whole formula and moved it to the S&P 500. And now, it’s a weighted average of this portfolio of options that’s meant to represent the actual variance of the S&P 500. So, I think that that was probably what got me really excited on the topic.

Kevin: Well, that’s a hell of a first project similar, not to go music too early, but I think about like, Guns N’ Roses’ “Appetite for Destruction.” You got to killer first album they’re working on the first instance of the VIX or the tradable side of it.

John: I think, back on it, and probably the most rewarding part of doing it was actually starting to talk to people like Peter and some of the guys on equity derivatives desk that have done research using the new VIX, or even explained to people how to use the derivatives on VIX. Some of the things that they’ve taught me about the way that you can use a measure of implied volatility are really impressive.

Meb: All that really made me want to do is go listen to “Use Your Illusion” I and II tonight and probably have some beers. But we’ll stay on this topic. It’s too early to get that cranking. But for the most people listening to this, they’re pretty familiar with VIX. They understand what it is. But what can people use it for? There’s a way that people talk about it in general, but I’d love to hear you all perspective, having talked with, I’m sure, thousands of different investors over the years. What are some thoughtful ways to incorporate VIX into a methodology or just a general approach? And also, what are ways that people misuse it?

Kevin: Those are great questions. And I think we could spend a great deal of time running through them. So maybe I’ll start big picture again. And as you’ve probably already seen, John can fill in some really fascinating details.

But so how could people use it? Sort of like options, broadly speaking, there are almost countless iterations and not necessarily a right one. But to your point, there are perhaps wrong or less right ones. And so, from a simple perspective, I think that any forecast is inherently valuable. And I look at VIX from, again, this simple perspective as a forecast for volatility. And like any other forecast, it’s going to be dependent on data and inherently imperfect.

But if I’m traveling or something, and I want to know what it’s likely to be, back when we did travel, wherever I’m headed over the next handful of days or weeks or month, I rely on a forecast. And so just from that basic level, whether I make decisions based on that, it’s probably going to play a role. But I look at, again, really simple as VIX as a wonderful forecast that sort of distils the market’s expectations for forward volatility. And we haven’t really drawn a line here. But I imagine many of your listeners understand that there are a variety of volatilities. You have realized volatility, which is a calculation of change that occurred in the past, right, and you can chunk that out over a number of different timeframes. And then we can use option prices to back out, based on our model, the expectation of forward volatility.

And going back to sort of how we kicked off, looking forward, the Nostradamus thing, we’d all like to be that, but it’s impossible. This is not a crystal ball. But it is a tool that can provide some insight as to the collective degree of uncertainty being priced into the market here and now. John, you could probably expound on that any number of ways. So, I’ll just keep it basic and let you run wild.

John: I mean, at a high level, or the most intuitive way, to me, I view the VIX as a tool to help interpret the things that we see happening. I remember when they told me that I was going to be part of this podcast, it occurred to me that I should read some of the things that you had published. And one of the blogs that I read, you made an analogy to the status of the market in terms of relating it to a blackjack player sitting in Vegas showing a 16 hand when the dealer was faced with 10 up card. And you were saying that it was kind of like the odds that your hand was going to be a loser, were pretty high.

You know, a lot of people talk about the S&P being that way at one time or another. And one of the guys on the equity derivative research desk that I’m pretty fond of, he writes a piece that makes use of VIX and I think he’s got this wonderful way of doing it. One of the things that he shows as a chart is the level of the VIX Index when the S&P 500 reaches historic levels. The first time it reached 3000, what was the VIX at? The first time that it reached 3500, where was the VIX?

And the chart that he does, when you look at it, you start to realize that it’s not very common for the VIX to be above 20 when the S&P sets new highs. And the reason that I talk about it like that and relate it to your blog post was that I often feel about the S&P that it’s, you know, reaching a new high and that maybe equity markets are overvalued. And I wonder, do other people think the same as me?

And I would use the VIX Index as a tool like that in the way that Rocky Fishman does for Goldman Sachs when he does that chart. And the VIX being elevated at the same time that the S&P is reaching new highs, to me, says that a lot of people share your sentiment or express the same analogy that the hand that they’re playing when equities are overvalued is a loser hand, and at particular points in time when the VIX is elevated at the same time that the S&P is reaching new highs, that’s a lot of people feeling the same way. And I think it all goes back to, you know, how the VIX is calculated and where it derives its different levels, right? The more people looking to buy S&P 500 puts, generally, the higher the VIX. So that’s how I tie those two together.

Kevin: Just to clarify, John, a point that you made about writing, you’re talking about something that Meb and his team put out, not me. Although I’d be really proud to take any credit for that. And so, you know, Meb, I read that as well. And when I saw there was a white paper about a tail risk strategy, I’ll readily admit that typically when I see white paper, I’m not all that pumped up. I’d rather be listening to GNR. But I have to give you and your team a ton of credit for the way that that was written.

I think, far too often, strategy pieces and pieces that incorporate coverage about volatility tend to be so niche as to be off-putting to a broader audience. But I think this is a topic that is incredibly important, whether you’re just getting started out investing or whether you’ve been doing it for decades. And so, I tip my cap for the work you did, explaining the handful of factors that might be valuable when you’re looking at hedges, what might make sense and why.

And then, just a little bit, maybe this will be another tee up for John, but something we haven’t mentioned is that over the course of the past two decades, there’s been an evolution from sort of this quantifying volatility with the VIX index, which is just that, it’s an index that measures, it’s not tradable, to the introduction of volatility futures at the CBOE or the Cboe Futures Exchange. And then, a couple of years later, options listed which trade based on the relevant or the associate, the same maturity futures contract. And I know John had a huge role in both the creation and the evolution of both of those products.

And not to toot our own horn, but I think volume in the derivative markets tends to be at least somewhat indicative of utility. And day after day, year after year, things like options on the SPX, the cash settled S&P 500 Index options or options on VIX as well as VIX Futures volume, are typically in the top five, at least as far as on the option side things go. And so, to me, I think that really is a testament to the broad utility across industry players of those option tools. So, John, maybe you’d elaborate a little bit more on either the evolution of the futures or what we’ve seen as far as the options are concerned and kind of the growth there particularly over the past couple years.

John: Yeah. And just to, I think, finish up on the questions that Meb had asked about, when do people misuse the VIX? I tried to make the idea or make the point earlier in my reply that a lot of the usefulness of the VIX as an indicator or a tool in helping us make sense of some of the things that we happen to see in equity markets is the idea that implied volatility generally tends to be inversely correlated with the returns of the S&P 500. And the way I did that was trying to say that when the S&P 500 declines, people tend to want to buy puts.

The way that I think people misuse the index, as a way of trying to make sense of things, is when they hold too strictly to that narrative and they say that that correlation has to remain negative. That if the S&P 500 goes down, the VIX has to go up. If it doesn’t, somehow the measure is broken. I see a lot of headlines sometimes where people write, “The VIX is broken.” The S&P went down and the VIX went up. And I think that’s a misuse of the index. It doesn’t have to have a negative correlation to the S&P 500.

And I think that the times when the VIX goes up at the same time that the S&P 500 goes up is one of those times that the VIX becomes most useful in explaining what we’re seeing in equity markets. You know, there was a time in March, in this year, where the S&P was down 4% and the VIX was down as well. And it was an interesting observation at that time because it was right into the middle of March when the realized volatility of the S&P 500 and equity markets in general tended to be very high.

The idea that the VIX would decline, and that give you another way to view it, implied volatility tends to be a mean-reverting measure. If it’s at 80, it’s more likely to go down than it is to go up. The historic average of the VIX over the time that we’ve calculated it using this methodology is somewhere around 20. If it’s low, like it was in 2017, throughout much of the year, around 9 and historical lows, it’s more likely that the VIX would respond sharply up to a drop in the S&P 500 because implied volatilities were so low. So, you know, I think, most oftentimes, people are dogmatic about the way that they use the index and the relationships between it and the 500. And I think that that’s probably what I would say about a misuse of the index.

Meb: There’s a lot of different ways we could go with this. I smile, as you talked about that paper, because had we done this podcast four years ago, you guys would have saved me three months of building my own options database. But instead, I realized at the end, that I could just play around with some of y’all indices that you publish and arrive at the same conclusion. So, listeners, you can certainly go to their website and find some really great series and monthly returns and all sorts of good stuff on all sorts of different ideas and strategies. So there, I saved you a full summer of drudgery.

But as we talked about this dance between the S&P and the VIX, and you guys have been through, like me, kind of three big S&P monumental events over the past 20 years: the internet bubble and crash, the global financial crisis, and then certainly this past year. How do you guys think about broadly hedging tail risk and ways to think about a stock portfolio?

Because the takeaway from the paper, part of it, was also, in the appendix, that particularly people in our industry are extremely exposed to one risk, and that’s U.S. stocks. Their portfolio, even if it’s 60/40, tends to have most of volatility in stock rather than bond. If you’re an advisor, your revenue from your business ends up being related to stocks. Clients panic at the bottom. If you don’t own your own company, you’re exposed to the whims of what’s happening. And on top of all that, stocks often are fairly correlated to the economic cycle.

The problem that we saw, and I think is challenging for a lot of practitioners, not just retail but pros alike, is this space gets pretty complicated, quick. How do you guys think about best practices, ideas, experiences, wherever you want to take it, thinking about hedging strategies in general?

Kevin: So maybe I’ll start there again. And, John, you can pick up or fill in details. But the point you led with where there’s any number of ways you could go, I think if you take one step back from that, what I find psychologically interesting is that we tend to see a huge uptick in interest around tail risk strategies. Let’s say in 2002, or 2010, or maybe like now or early next year, like after these events occur, and that sort of hindsight bias, I find fascinating, especially with this sort of rational actor assumption that econ-types approach of valuation of this type, and we’ve already mentioned the analogy about everybody trying to look to insure their homes after they’re on fire.

But I think about it, like I don’t enjoy paying home insurance, but in the event that some disaster strikes, I’m going to be grateful that I have that. And a tail risk strategy, from my perspective, is structured to insulate yourself against some specific disaster, typically, a significant pullback in your portfolio value. And one thing that, Meb, you just said, everybody is typically exposed in a similar way. So, one of the ways I look at that is most people are implicitly short volatility. And so, when volatility moves up, particularly when it happens with some velocity, like it did earlier this year, or in any of the other timeframes that we talked about, there’s panic, right?

And we see this cycle after cycle and all sorts of people look for protection at the same time. And in that sort of situation, you have a supply-demand imbalance, and the cost of insurance goes up. But people that tend to be more proactive than reactive, I think, are generally amenable to the idea of, “Listen, I want some potential protection in place” because this is going to happen at some point in the future, the likelihood of timing that, which again, going back to your paper, I thought was really well handled, nobody is going to time the market perfectly over any stretch, right? So, like, my monthly insurance premiums, I’m not looking to time that, but I know there’s some drag.

And then, the art becomes how do I structure that insurance? Because there are far more creative ways to do that in the derivative markets than at the insurance business. And so, to that point, we could have, I think, an interesting discussion about the relative value of outright S&P 500 index puts, right, that establish a floor at some point that you’re comfortable with, whether it’s 10% out of the money or 20%, or what have you, some very specific level, versus some exposure to long volatility either with VIX futures or VIX options, which will behave differently. And that’s stuff that when I listened to John in other presentations he gives, really gets into the weeds, but it’s fascinating. And so, John, I don’t know if that’s something that that you want to talk about. But if you do, I think it could be illuminating for the audience.

John: I think the first thing that I would say about the complexity of this topic… And I think it tends to get more complex, the more bespoke that you get with how you look about hedging, right? In one of the presentations, I think that Kevin might be referring to, you’ll look at it and you say, “Well, if I were interested in hedging an S&P 500 portfolio, how frequently should I do it? Should I buy monthly puts, or should I buy a one-year or two-year leap? And you can backtest all kinds of these strategies, and over certain market environments, it might be more beneficial to once per month, buy a 10% out of the money S&P 500 put.

I mean, if you looked at it, in 2020, probably made more sense to hedge monthly than it does annually. If you just bought a December leap in January and thought that that was the appropriate way to hedge, it would be the case that we had this severe 30% downturn in the S&P in March. And then we immediately saw the S&P come back, and now we’re going to be up for the year. And that purchase of the one-year put, well, it had some market-to-market gains in March, if you’re still holding on to it, you probably paid the premium without ever actually using the hedge.

You know, you start talking to people about, “Well, then should I have rolled the put to a lower strike in March?” And that’s when you start to get into the, you know, all of the complexities that people refer to about hedging programs. It would seem to me that there’s probably not one universal truth or right way to implement a hedging strategy, but there probably is a right way depending on the situation of the person looking to implement that hedge strategy.

Kevin: So, one other thing I might add to that is, I think, if you have a hedge, John, of any sort, right, even a sloppy kind, which I’m not advocating for, but any kind of hedge likely affords you a different mindset in the middle of March than someone that’s fully exposed. And there’s flexibility that’s associated with that. If you’re not looking at a portfolio that is down 35% in the middle of March, let’s say you have that hedge on and it has worked to a significant degree, you have the potential to maybe put capital to work in that situation when most people are making emotional decisions that tend to look stupid in hindsight.

So now, I’m a little bit recalling a podcast that, Meb, you did fairly recently with Marc Levine, who I think sat on the Illinois State Pension Board or Investment Board. And one of the points that he made or the two of you spoke about was this belief that, something to the effect of, avoiding bad decisions can sometimes be as important as making a series of good decisions. And I think that’s the point that a lot of people overlook. It’s easy now to say S&P 500 at all-time highs. But the picture was so different and the future looks so murky in the middle of March. And to assume that you just stay the course, I think that’s far easier if you have a hedge in place than if you don’t.

Meb: Yeah, I mean, we talk a lot about the behavioral aspect. I mean, there’s a great book that Josh Brown and Brian Portnoy put out recently called “How I invest My Money.” And I think a lot of people would have the belief that it’s going to be very specific about their exact investments. It does talk about investments, but really is this very personal squishy walkthrough about how people have a relationship to money. And this concept of not exactly mean-variance optimizing everything, right, where so many of these advisors said, “Hey, look, you know, I pay off my house. I realize, on Excel, it’s better to have this mortgage. But for peace of mind, I like having a house fully paid for.”

And the same thing applies to investing, I think. I said, if you look back at this year, if there’s one lesson a lot of people can think about is, is it the most important thing to be maximizing returns three decimals? Or is it more important to have a sort of sleep-at-night portfolio and thinking about the behavioral side of, look, you want to own stocks in the long run. You want to own businesses. Obviously, I like ones in foreign markets better currently, but you want to own, and that’s what we get paid for, but they’re volatile as hell and they had a huge drawdown. So, to have something, anything that may be doing well, in those bad times, which happen. You know, that’s what markets do is I think it keeps people from getting to that end goal is useful.

We’d love to hear you guys talk about 2020 in general. Any big takeaways? I mean, there’s always a little bit of drama going on the institutions. You had CalPERS at the beginning of the year, all their tail risk, everything going on with Masayoshi Son. Right now, they had news out today that they were ceasing their options program because of too much blowback. Any general thoughts in just 2020 in general, lessons learned, things going on, gossip, anything else you all want to talk about?

Kevin: From my perspective, 2020 has been fascinating for a variety of reasons. If I just speak really broadly, from an options-industry perspective, we’re on pace for a blowout year in terms of volume. That’s wonderful, I think, at least from the work that I do, and I work in the education arm of the exchange. That’s also a huge opportunity because we’ve seen a massive amount of take up on the part of seemingly newer investors and the opportunity for education, which I think is imperative, is becoming bigger. But people are becoming much more comfortable with the idea of using options to gain exposure to a market of interest, whether it’s domestic or international, or something very nuanced.

And then, you’ve also seen the market make moves that we haven’t seen in some situations, kind of ever, but for quite a few years. And I think that that’s healthy. So, I think the broad market behavior that we saw, going back to like 2017, was an aberration. And if you’re new to this, the realization that volatility is an omnipresent, very real risk is a good thing. And maybe I’m clouded because I think you’re impacted by like the early stages of whatever it is you decide to pursue. And so, I started in this business at the very end of 1999. And I saw the sort of, and I also happen to be kind of interested in the behavioral side of things, the tail end of the NASDAQ boom, where for those of you that are maybe younger or don’t recall, the NASDAQ Composite doubled in about six months between late 1999 and March of 2000. And then lost something like 80% of its value into the bottom in 2003.

But more recently, we haven’t seen even those typical calendar-year drawdowns, that psychological reminder that volatility matters, that perhaps I should consider tools that could mitigate this exposure to a certain degree. During a typical calendar year, the S&P 500 typically experiences somewhere between a 12% and 16% peak-to-trough decline. And, just not to beat on 2017 too much, but you go back a couple of years and the biggest peak-to-trough pullback in 2017 was 2.8%. That is unusual.

I think you could talk about, and maybe you want to, John, maybe you don’t, but the impact that things like fiscal and monetary policy have played in potentially muting macro volatility both here in the U.S. and globally, and just from a pure VIX standpoint, to see the index in the middle of March make closing highs, a level 82.69 that exceeded any closing level, even in 2008, is fascinating. And I’m not making light of that because I know it was incredibly difficult for many investors. But seeing these measures that have become global bellwethers continue to play a significant role in the overall ecosystem is incredibly exciting, and a huge opportunity to educate people on how these tools work, why more and more people are using things like options and index options, specifically, and the fact that volatility is and will be an ongoing risk. John, you could do much better than that, I imagine.

John: I’m not so sure about that. But I think that if I had to take one or two observations that if you had asked me in January, if these things would be true of 2020, I would probably have not said that they would be. The first one is, for a long time, from probably 2017 onward, maybe even 2015 onward, you saw declining volume in equity options. In 2020, you know, you can look to the increase in liquidity in option volume and individual equity options and even in some of the options on the ETF. I mean, if you were to look at Spider options, and you look at the breakdown of volume in Spider options, I think it goes to the point that Kevin might have been making with the new users of options products, right?

And the way they use options is somewhat changed during 2020 as well from the standpoint of, you know, it used to be the case that an option trade was a relatively longer dated trade. And now, with the advent of weeklies and things like that, the holding period for Spider options has gotten significantly shorter. And if I look at the volume in terms of one lot in Spider options, it winds up being over 100,000 contracts a day. So those are what I would characterize as fairly small accounts using options. And there’s been some growth in that volume during this year. Some of the commission-free platforms for brokerages for trading options, I think, it probably led to increased adoption of some of those things.

And then, the second trend that I think is different in 2020 is the elevated level of the volatility of equity markets and the elevated level of the VIX itself. I mean, the VIX has been above 20 for pretty much most of the year since March. And that is an aberration when you look back to where it was in 2017, 2018. A VIX over 15 was a remarkable thing during 2017 to 2019 period. And now, a VIX below 20 would seem like an aberration in 2020 following March. So, I think those were the two big trends in 2020 that I wouldn’t have anticipated standing in January,

Kevin: Maybe just to give a little bit more color to that. The average closing level for the VIX this year, just recently inched below the 30 level. And that compares to an average last year of 15.4, the year before like 16.60, and 2017 was the lowest average VIX level at 11.1. The last time over the calendar year that the VIX was in the ballpark of 30 for the year…so if you go to 2011, where you had the European sovereign debt issues and the first-ever U.S. debt downgrade, the average then was just below 25. 2009, the average was 31.50 and 2008 was 32.70.

So, we are in an unusual period for the market, but it’s not unprecedented. And I think that, again, loops back to Meb’s point about understanding that these things do happen and there’s kind of been a significant dearth of volatility for the past few years that can change psyche and change behavior. And I’m not saying that this volatility is going to continue into next year or beyond, but if we did get into the futures term structure, which might be a little esoteric, but the futures have remained elevated throughout post March, and they do signal the potential for relative to historical norms, elevated volatility well into next year.

Meb: I mean, we still got a month left of 2020. I don’t know what you’re talking about. I think it’s alien invasion. We got weeks to go. 2020 is not over yet, gents. The fun thing about talking about options and futures and derivatives and all the work you guys do, you have some great indices, some of these go back to the 1980s. And they always have fun names like Delta BuyWrite, or Iron Condor, or Smiles, everything else. We’d love to hear you guys talk about a strategy or an idea that you think people would like to hear more about.

John: One of the things that’s always fascinated me in terms of the way people think about equities is the idea of diversification. You know, do you think that if I go ahead and I hold a diverse enough group of equities in the United States that I’ve got a diversified portfolio? And I’ve always thought that there was something amiss in that idea, right?

I mean, if you look back into March of 2020, and I try to calculate what the correlation is amongst the stocks of the S&P 500, which kind of characterized as, well, it used to be any way, a broad market measure, when you have events where equities are down, those correlations are not static numbers, and they tend to change over time. And in periods when the market goes down, those correlations tend to go up. So, the idea that I have some diversification benefit by holding a large basket of equities within the United States, to me, when you have normal returns, probably that’s the case, but when you’re really interested in something like tail risk or a large decline in the S&P 500, those correlations go to one and that diversification benefit is somewhat lessened in my view.

So, one of the measures that I was keen for CBOE to do when we first started publishing, I think in 2009, was an idea that we use individual equity options and options on the S&P 500 to publish a measure called the Implied Correlation Index. And basically, what this is, is the option market forecast of what the correlation amongst the stocks in the S&P 500 is going to be over a period of time. You know, that number typically ranges somewhere from 30% to 100%. And you can kind of see, in times like March, that number begin to spike, and it gives you an idea or can be used as a metric to give you an idea of what people think the diversification benefit of holding all 500 stocks in the S&P 500 is going to be, right? If you know, if you could get to an idea where you could actually start to quantify a dispersion risk or dispersion risk management tool, I think that that’s probably where I would start to go with that Implied Correlation Index.

Kevin: Who would be interested in that? And what might they glean from changes in those measures? I’m kind of being devil’s advocate here.

John: So, I think, right, you know, if you were to calculate at the money implied volatility of an S&P 500 Index option, and you were to compare that to the market cap weighted average implied volatility of the stocks that make up the index, there’s a difference between the two. And that kind of hits at the idea of risk premium embedded in index options. So, you know, if it were somebody that were interested in implementing hedging using S&P 500 options, I think it is instructive to look at implied correlation in what the equity options market is saying for implied correlation as to whether or not a hedging program makes sense at a given point in time. I’m just trying to add to the complexity that Meb was referring to earlier, I suppose.

Kevin: Well, I appreciate that addition, that helped clarify it for me. Maybe to diminish that complexity, I’ll talk just a little bit about the evolution of CBOE benchmark indexes. And so, you have to go back I think it’s 2002 or 2003. When we first published BXM, which is a one-month BuyWrite, where a portfolio is long, the S&P 500 total return and sells monthly S&P 500 at the money options.

And so, the world has changed so dramatically in the interim. Like prior to that, institutional money, and, John, you could correct me if I’m wrong here, but the institutional embrace for equity or index options was relatively small and they would come to CBOE as an exchange and say, “Listen, we need data that I can show to my investment board that illustrates how and why this can smooth out my risk-adjusted returns or something to that effect. Show me periods of out or underperformance.” And so BXM was the first benchmark index where institutional types could point to this as a means to improve my risk-adjusted returns over given timeframes.

And since then, this suite of benchmark indices has grown dramatically. I think there’s something like 35 now. The kind of belle of the ball over the past decade or so has been a S&P 530 Delta BuyWrite Index, so very similar to BXM in that this hypothetical portfolio holds long exposure to the S&P 500. But instead of selling monthly at the money options, they are 30 Delta options, which are going to be slightly out of the money. And so, if you think about the tendency for the market to move higher over discrete timeframes, you’re capturing more of that by using an out-of-the-money call option, but still bringing in some premium that potentially adds to your yield over time and gives you some degree of downside cushion, month after month.

And then, if I thought about the concept that we’ve spoken at length about here, kind of tail hedging, and 2020. So more contemporaneous, this VIX Tail Hedge Index, the ticker there is VXTH. There’s a whole lot of interesting research on our site about that. But I think if I had to make one primary takeaway, it’s that really small allocations to ideas like this and products that exhibit the convexity that you see in particular in VIX options during periods like we saw in February and March of this year can make a huge impact on an overall portfolio.

So, this is something again, Meb, your white paper on tail risk and the approach, pointing out that relative to the overall portfolio, small allocations to tail risk ideas can have an outsized impact. So, you elaborate it on the asymmetric risk profiles or risk reward profiles, something like index options, and I think you could walk that even further and talk about things like VIX futures or VIX options. And so, I guess long story short, I think it would be valuable for some listeners to check out CBOE’s benchmark indices to see timeframes where specific approaches under and outperform. And then if there are questions about the how and the why, to come back to someone like myself or John to have that clarified.

John: What I’d say about CBOE’s benchmarks, generally, is I think that prior to us doing the BXM, it was a problem for some of the institutional users of options to have a benchmark that they could compare any implementation of an option strategy that they were using to. And I think that something like the BXM, on an override strategy, certainly played a large role. And we spent a lot of time developing that with people so that they would have something to benchmark their overriding strategy to. So, I think it was a useful exercise to create indexes like that.

Most of the time, in my role at the exchange in new product development, it’s to attempt to create an index something like the VIX that can serve as the basis for a novel, cash settled derivative contract that we could trade in equity markets. So, there’s a little bit of a different focus for what I do, but I can see the utility of the benchmarking indexes that we do as well.

Meb: You guys want to talk to me about variance futures?

John: Sure, I mean, variance futures is, in fact, one of the interesting things that I think of from a tail risk perspective. I think I’d made two points there, right? I mean, one of the issues about hedging and using even S&P 500 index options or VIX derivatives is the idea that, at some point, you have to monetize your hedge. And so, I think back to the example that I was talking about with the December leap at the beginning of this year, and the idea that the market was down 3% in March, and if I didn’t monetize my hedge, all I’ve done this year is pay premium for a one-year option, only to see the S&P go up, right? I was right about the idea that the S&P was going to go down in buying the option, but I would have had to monetize the hedge at the right time in order for that to have been a benefit to me.

The interesting thing about something like a realized variance future is the idea that that volatility that we saw in March has become part of the settlement value, right? So that decision to monetize a hedge is already been incorporated into the settlement value of the contract. And that decision is somewhat removed from you. You don’t have to make it.

The other issue about it is, is that it’s a convex pay-out, right? It’s something that nonlinearly with an increase in volatility. So, it’s an interesting contract. It’s been around in one form or another at the exchange since 2004 when we listed VIX futures. Obviously, we haven’t seen the same types of trading volumes that we see in the linear product, in volume terms, the VIX future. But in my mind, any contract that incorporates some aspect of realized volatility, and it’s not just on implied volatility, has some interesting characteristics for people who are looking to hedge. Kevin, did you have anything you want to add?

Kevin: I do have a question for you, Meb, and you can defer or whatever. I’m curious from your conversations or your team, where the interest lies in this concept, this strategy of tail risk, and has it been constant? Like if you look back the past couple of years, do you see very significant level of interest now whereas there was none three years ago? Or what from your perspective?

Meb: You know, I think if you go back in the history of investors, last 20 years, we could walk through every 2 years, what people were excited about. So y’all cut your teeth late ’90s, as did I. I was trading dot-commers during class in the late ’90s so were my professors. Fast forward a couple years, people were interested in dividend-yielding stocks, small cap REITs. Fast forward couple years, people were interested in commodities, emerging markets, BRICS. Fast-forward a couple years, people are interested in trend following, anything with yield the past decade, on and on.

And so, you know, there’s always… And now, 2020, SPX, right, nothing new, but been around for 100 years, shiny new object. I think people are always interested in what can I combine to the traditional 60/40 portfolio to smooth out this roller coaster. And, you know, all the things I’ve mentioned have had, any asset class, its moment in the sun, whether it’s gold, or real estate, or cryptocurrencies, and trying to come up with a way to blend those together. The challenge is most assets tend to be fairly correlated over long periods of growth. So, the buy-and-hold investors, traditionally, the biggest challenge of buy and hold is that it has its worst performance, because of the domination of the equity-like instruments during times when your human capital is also exposed, so during recessions, and really bad times in the economy, think about this year.

And so, I think over the past few cycles, people have certainly been interested. I think there’s a much bigger education gap when it comes to derivatives of any sort and tail risk strategies versus some of the others. I think it’s pretty simple. People can’t understand REITs. You know, they own a house, they understand commercial real estate. Commodities are probably in the same bucket as tail risk strategies because, they, in most cases, require derivatives, right? And again, I’m speaking to not just individuals, institutions too.

I think it’s been a challenge, you know, how to implement them, how to think about them. The most important thing, certainly with not just, again, individuals, but committees, big institutions too is what’s the story? You know, what’s the narrative behind this idea or this product? Can you explain it in a way that makes sense? And so many things in our world… You know, we’re the quant nerds, right? We could spend six more hours getting into the specifics of some of these strategies and ideas, but trying to convey them in a way that makes, I think, a thoughtful sense.

And lastly, the practical element, how do I put this together as a piece of a cohesive whole and talk to people about it? The one area that I’ve seen a pickup and even more interest is, what the hell do people do about bonds? I think the average investor is scratching their head saying, “You know, these government bonds are giving me less than a percent. I charge a percent, you know, the average financial advisor, how in the world is this going to work?” And worried about rising rates, and all that comes with it, God forbid the rest of the world, it’s negative so the conversations, of course, evolving, are back into all-time highs. But I think there’s a definite interest in all sorts of types of tail risk, not just stocks.

Kevin: I appreciate that. I totally agree with you that you can get in the weeds, but there needs to be a succinct and compelling story. And there’s a small group, I think that is good at explaining that to a wide audience. And again, I think that speaks to the way your white paper was written, and threading that needle. So, well done.

Meb: So, as you guys look to the future, what are you guys most excited about? And it could be either be a researcher you’re working on, it could be initiatives at the exchange, anything that comes to mind.

Kevin: I’ll go first. Mine is relatively simple. I am excited to get back to work. And I know I’m not allowed to get back into an office to a return to something more akin to “normal,” but I’m particularly excited about that, because the exchange is moving headquarters from La Salle and Van Buren to the old post office in Chicago, which has a really storied history. And we have an awesome space there. And I think it’s going to be much more collaborative and exciting.

And then, specific to the team that I’m a part of, the Options Institute, we’ve been able to grow this year, which is super exciting. And the team we’ve put together is pretty amazing. And so, the combination of an uptick in the use of options gives us huge opportunity to educate people on the utility as well as the risks inherent in any tool that we discussed today. And so, I’m looking forward to being in the office, having more of this sort of spontaneous conversations with people like John and getting out and advocating for the informed use of options, generally.

John: Yeah, I think that I would add that I’m also in favor of a return to normal with respect to our social interactions with other people. I don’t mind the virtual world all that much, but I do appreciate being able to walk down the hall and have a conversation face to face with somebody. I think the other thing that if I were talking about a specific initiative that CBOE were undertaking in the future, I think that the idea that CBOE is going to start a brand-new derivatives exchange in Europe is a pretty exciting concept to me. You know, the idea that we could maybe expand upon the equity derivative trading model that we have here in the United States and bring some of that to Europe and actually see equity options trading in Europe on a CBOE Exchange is a very exciting concept in my mind.

Meb: You guys both have been through a few cycles. As you look back over the past 20-plus years, are there any particularly memorable investments either you guys have made? They could be good. They could be bad. I know, it’s been everything from clerks to market makers, and everything in between? Is there anything comes to mind for you guys?

Kevin: Man, this goes back to the psychology but all that pops front of mind now are the bad things, right? Like, you’re in a business for quite some time, but if you’re doing your job well, you’re protecting and growing capital, which your podcast promo says at the outset. And I think that’s awesome. But that’s like, this business is unique in that respect, where your job is to protect and make money, right? And that is fairly different than just about any other line of work.

And so, I appreciate when I’m around people in this business that talk about difficult periods and, ideally, learn from them. And I hopefully challenge myself to continue to be that way. I think far too often the greed side of things is what is marketed, and unfortunately, that’s effective with some audiences.

But I learned from people that are candid about really difficult times. I remember a handful, like I’ll never forget, a stretch in, I think it was 2004 where there was news on Merck that Vioxx was increasing the likelihood of heart attacks in patients or something. And we had on this group I worked for had a dividend play strategy where, without getting too much in the weeds, you exercise in the money calls to try to capture a dividend. And synthetically, you’re giving up this out-of-the-money put for some timeframe until it expires. And the time between trying to capture that dividend and expiration, this Vioxx news came out, and it kind of wiped out our small group’s year.

And things like that will stick with me as long as I’m around here. And so those become, hopefully, learning moments. And being able to talk about the how and the why that happens and learning from it is something that I try to remind myself of regularly. So, I could chew up a half hour here talking about terrible ideas, but I don’t think anybody wants to hear that.

John: I think the most prominent thing on my mind would not be any particular trade, it would more be a product. I’m a huge fan of exchange-traded products like ETFs, and ETNs. I mean, the idea that I can buy or sell the entire S&P 500 with one trade in a Spider share is, I think, a particularly powerful tool to me. Not only is it a powerful tool, but the back and forth in terms of people talking about the impact that it has on equity trading in the United States and the idea that there is so much money indexed to the S&P 500, and index funds have become such a large portion of investments, and what does that do to diversification and the correlation amongst stocks if most of everybody’s investments are indexed. The idea that there’s so much to talk about from the development and growth of that market is also interesting to me.

The last point I’d make about it, I think, is the idea that just trading the entire market in one trade is a nice thing. But even some of the trading strategies that have been embedded within exchange-traded products and getting access to those in a cash account to a broker dealer, because it trades like a stock, really kind of is an interesting point as well, right? I mean, the idea in 2017, that I could trade XIV or SVIX, which is basically the inverse of holding the front-to-month VIX futures. So, I could be short, forward implied volatility through trading it like a stock was a fascinating thing. And also wound up being a pretty decent trade in 2017.

But it really opens up a lot of different trading strategies to me within a 401K account or a personal retirement account that otherwise wouldn’t have been there. Obviously, it raised all types of suitability issues and questions that need to be sorted out as well. But I think it’s an interesting product. And I’m a big fan of it.

Kevin: Are you talking too about the growth in the defined outcome in the listed market products, John, or am I misinterpreting that?

John: No, I don’t think that I was necessarily talking about defined outcome products, just the format of an exchange-traded product and some of the things that have been put into it. I cited XIV because I traded it and it was the idea that you were trading forward one-month implied volatility of the S&P 500. But you were trading it in the format of an equity issued and traded in a secondary market. It was fascinating to me.

Kevin: I totally agree with that. And it just then triggered in me the growth and availability in unique accessible structures like funds or ETFs of these defined outcome products, which CBOE plays a role either directly or indirectly, and how more and more people will now, at least theoretically, have access to structured-product-like investments, which in many situations, they’ve been priced out of, historically. And I think that democratization of strategies like that is inherently a good thing. So, I appreciate your sort of calling that to my mind.

Meb: Gentlemen, this has been a blast. We’d love to talk about all sorts of other weird stuff. So maybe we’ll do a follow up in three or six months and do the super weird show.

Kevin: “Use Your Illusion III”

Meb: Yeah, those that weren’t ready for the super weirdness. You guys put out a ton of good research. Where do people go? Where should they follow you guys? What’s the best place?

Kevin: All right. So, this is a great time to highlight this because we’ve been updating a whole bunch of material. And if you just do come through the parent website, CBOE, cboe.com, you’ll be able to much more easily navigate to areas of particular interest, whether it’s index options, volatility, education, what have you. And that’s tip of the cap to the web development team. I know they’ve been working on that for a really, really long time and they probably never get shout outs on a podcast like this. So, to those guys and girls that have been working late nights redesigning the website, well done.

Come to cboe.com and find out what you need to. And if there are kind of nuanced or specific questions, you will be able to find or get answers from somebody, John or myself or somebody else in the Options Institute, send them in, we welcome them. It keeps me in work.

Meb: John, Kevin, thanks so much for joining us today.

Kevin: Thank you for having us.

John: Thank you very much for having us.

Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us an email at feedback@themebfabershow.com, we’d love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening friends and good investing.