Volatility of volatility spike drives options liquidity squeeze

Options market metrics suggest dealers have navigated volatility surge without serious pain - but the market did experience a brief liquidity squeeze

It is too early to give the industry a pat on the back, but equity derivatives traders feel they deserve it. Realised and implied volatility leapt in August without – they claim – triggering the kind of pain seen in May 2010, when a similar jump caught many banks out. This time, bid/offer spreads widened and liquidity decreased, but less violently than last year, dealers say.

“As intra-day volatility spiked, market-makers had to charge more to cover themselves against huge intra-day market moves, so their bid/offer spreads widened,” says Aymen Boukhari, an equity derivatives strategist at Société Générale Corporate and Investment Banking (SG CIB) in London. “But it was a very short-term effect – it was a sharp squeeze for two or three days, but then reverted towards previous levels.”

One of the most notable features of the market’s behaviour was its mood swings. Volatility was not constantly high – instead spiking and falling back, before reasserting itself. In other words, the volatility of volatility (called vol of vol by traders) was high, which can be painful for dealers who are exposed to shifts in the volatility level as a result of the options business they have written.

SG CIB’s metric for vol of vol – a five-day moving average of the intra-day peak-to-trough percentage changes in the VStoxx implied volatility index – soared from 6.8% to 23.1% in the period from July 29 to August 12. This coincided with a jump in the bank’s proprietary measure of options market illiquidity, from 4.5% to 7.6% – a larger jump than in May 2010, but below the 8% level reached then (see figure 1).

Market-makers had to charge more to cover themselves against huge intra-day market moves, so their bid/offer spreads widened. But it was a very short-term effect – it was a sharp squeeze for two or three days, but then reverted towards previous levels

According to Emmanuel Dray, global head of equity derivatives flow trading at BNP Paribas in Paris, last year was so difficult because many banks went into the period with a short volatility position, leaving them exposed when equity markets eventually reacted to the unfolding sovereign debt crisis in Europe, and causing them all to buy volatility at the same time – liquidity dried up and losses deepened. Dealers seem to have coped better with the latest bout of turmoil, he says, pointing as evidence to record volumes in options on the Vix index, which measures volatility as implied by S&P 500 option prices. Vix options hit a peak of almost 1.2 million lots traded on August 5.

“People learned the lessons of May last year to the extent that positions are more manageable. Partly because of the demands of the structured products market, back then everybody was short volatility – now dealers are much better covered against it. It’s no surprise that you get wider bid-offer spreads in a high vol-of-vol environment, but people that wanted to rehedge could still do so, as you can see by the record volumes in Vix options. We kept our downside protection on in July, when we realised the market wouldn’t be satisfied with the proposals from the European Union’s sovereign debt crisis summit.”

SG CIB’s Boukhari agrees dealer books were more balanced this year, enabling them to weather August’s storm. “As investors clamoured to buy back their short volatility positions last year, there was nobody left to take the other side of the trade, so illiquidity spiked hugely. This time, positions are more mixed, and most investors are well hedged – if anything they are underexposed to equities. The options liquidity short squeeze in August was milder by comparison.” Boukhari says long-term Euro Stoxx 50 at-the-money implied volatility and skew remained well below the levels they reached in May 2010 (see figure 2).