As many of you know, I spend a chunk of my time looking at SPX volatility...almost to the point of obsession. Over the last few days I began to notice that the term structure was getting out of whack. Today I was about to write a piece about how ATM short calendars looked like a decent trade, as I think April was oversold. My thinking was that ahead of the employment report, there is no way that April should be 1.5% cheaper than May. It was then that I caught a glimpse of the implied volatility of the weekly options relative to regular April and May. I thought nothing of it, but then I noticed the volume of on those strikes. Take a look at this montage of the ATM SPX Options across several contract dates.
I want you traders to notice two things:
1. The IV's of the weekly options relative to April and May
2. The Volume in the weekly options relative to April and May
Notice how much volume the Weekly's had in the At the Monies relative to April and May. On the 1325 strike the weeklies did about 59% as much volume as the regular months (If I added the 1330's that number would go up more). That is not an insignificant number. Now, look at the implied volatilities of those weekly expirations. Notice how much higher they are than April and how relatively on par they are with May?
Traders, let’s not forget that this Friday is the government employment report. There are a lot of traders playing this number. It appears, based on the volume trading in the March weekly’s, that a huge portion of customer paper hedging or speculating on the employment number is trading in the weekly options. In fact, the IV of the March Weekly 1325 strike actually went up today. Yet, the VIX has been on its way down all week…How is this possible?
The answer is quite simple. If one reads the white paper on the VIX, it clearly states that it stops counting options that have less than one week to expire. This excludes every weekly option! If the VIX is supposed to be a measure of how IV is moving, how can it discount a huge portion of the activity playing a specific event? It shouldn’t!
The index, while still a good index, is probably going to have to change at some point in order to take into account the activity that has begun playing event risk in the weekly options. Another option might be to have some sort of short term VIX that takes into account the action on the weeklies. If nothing is done, traders will notice the VIX actually begin to smooth out. This will also cause the 'vol of vol' to fall. This might eventually cause the VIX to become an obsolete product.
So far the CBOE has done a great job of producing volatility products. While the weekly's (another one of their great inventions) have been a huge boon to investors, the VIX and some of the other CBOE products may have to be adjusted or risk losing their ability to measure implied volatility.
If you have interest in learning more, check out the recordings of our L2 Prep Course, you can purchase the recordings here. Make sure you check it out, we have a very special offer listed on the page.