Low VIX caused by ETFs, not options-hungry day traders, says the BIS

By Jamie Chisholm

Report helps explain why volatility muted during uncertain periods

Persistently low levels for the CBOE VIX index are likely the result of investors piling into yield-enhanced exchange traded funds, according to the umbrella institution for central banks.

The Bank for International Settlements, based in Basel, Switzerland, says in its quarterly report published Monday that a low VIX of late is unlikely to have been caused by retail traders' predilection for buying short-term options and was instead caused by the popularity of structured products which offer higher returns to investors by selling options.

Options give investors the right, but not the obligation, to buy via a call or sell via a put, an underlying asset at a particular price within a certain time period.

The CBOE VIX index VIX is a popular gauge of expected equity market volatility which is calculated from the cost of one-month options on the S&P 500 index SPX. At times of market stress traders tend to scramble for the protection that options provide, pushing up their price and thus raising the VIX.

However, as Karamfil Todorov and Grigory Vilkov at the BIS note in their report: "The compression of equity market volatility throughout most of 2023 seems puzzling. Despite the prevailing uncertainty stemming from interest rate paths and geopolitical tensions, the VIX remained below its long-term average of around 20 for most of 2023."

One theory why the VIX has hovered at lower levels than many observers consider apt focuses on the explosion in trading by retail investors of one-day to expiry options, or 0DTEs.

"Low premiums on 0DTEs allow investors to build in very high leverage, hence the lottery-like payoff profile. In fact, leverage ratios of 0DTEs are several orders of magnitude higher than those of one-monthoptions and can reach levels above 400," say the BIS pair.

0DTE options on the S&P 500 became so popular that they accounted for more than 50% of the SPX options' trading volume in August 2023, up from just 5% in 2016, according to the BIS.

It is thought that activity in these ultra short-term derivatives has drawn trading volumes away from the one month-to-expiry (1MTE) options that underlie the VIX. However, this is unlikely to explain the drop in VIX for two reasons reckon Todorov and Vilkov.

First, even though both instruments have grown in past years, one-month options are still used disproportionally more than 0DTEs to get actual exposure to the market index itself, they say.

Second, 0DTE trading activity does not directly affect the pricing of one-month options and thus the VIX, because the latter is based on one-month maturity, whereas 0DTEs expire on the day of trading.

Todorov and Vilkov also note that whereas the selling of VIX futures in short-VIX exchanged traded funds may have been behind a lower volatility reading in 2017-18, recent years has seen net positive demand for VIX futures, as the purple line in the chart below shows.

But what that chart also shows is the surge in fund flows into covered call exchanged traded funds. And it is this trend that the BIS pair said is behind a suppressed VIX of late.

There are different types of yield-enhancing structured product, but the covered call is among the most popular. A simple version for the broad market sees a purchase of the S&P 500 index and a simultaneous sale of a one-month call option on the index. The money raised by selling this call option, which is covered by the ownership of the underling index, adds to the income of the ETF.

Crucially, the rise of yield-enhancing structured products may dampen volatility not just because increased volumes of calls are sold but also due to the mechanics of how dealers hedge option exposures, say Todorov and Vilkov.

Dealers need to buy when the index goes down and sell when it goes up -- a practice known as dynamic hedging.

"By doing so, dealers act in a contrarian way, effectively dampening the price movements of the underlying asset. As volatility declines, so does the cost of ensuring against it, as reflected in option prices," say Todorov and Vilkov.

"Such market dynamics could explain why the VIX can be depressed even in an environment of heightened uncertainty," they conclude.

-Jamie Chisholm

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03-04-24 0758ET

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