Options on Volatility
As options markets are pricing in volatility related to the U.S Presidential Election, we have a great opportunity to discuss options on volatility itself.
The ProShares Ultra VIX Short-Term Futures ETF 1.5x Shares (UVXY) is a leveraged exchanged traded fund.
UVXY holds a basket of CBOE VIX futures (and cash) to seek “a return that is 1.5x the return of its underlying benchmark (target) for a single day, as measured from one NAV calculation to the next.”[1]
UVXY has an options implied volatility (IV) surface with three unusual features: (1) call skew, (2) concavity, and, as we are writing, (3) contango.
IV Surface for ProShares Ultra VIX Short-Term Futures ETF 1.5x Shares (UVXY)
(Formerly 2x levered)
Call Skew
Each expiration in the UVXY IV surface exhibits call skew. We addressed the topic of so-called positive (call) skew in a previous blog.
Call skew occurs when the “call side” of the volatility smile has higher IV than the “put side.”
To recap, call skew primarily occurs when (a) there is strong OTM call demand, (b) options market makers (OMMs) are charging extra to be short OTM calls, and/or (c) some combination of these two factors.
For UVXY, the OMM risk management explanation is the most likely. Why?
Increases in VIX can be sudden and violent. The risk to call sellers has historically been much greater than the risk to put sellers.
So, market makers charge extra for calls and manage their risk(s) effectively. The result is (much!) higher IV on OTM calls than OTM puts.
UVXY Price Chart, 2024 YTD
Source: TradingViews
Concavity
A more unique feature of the UVXY IV surface is concave smiles in almost every expiration. This is highly unusual! Why?
In a “normal” volatility smile, OTM options have higher IV, and thus a higher “price” (in vol terms) than ATM options.
One way to think about this is that OMMs charge more to be “short” for the most extreme price movements.
For UVXY, however, the most extreme OTM call options have the same IV as more ATM neighbors.
In some cases, deep OTM calls have lower IV than less OTM calls. How can this be?
Certainly, volatility is not bounded on the upside. The IV of the market can increase to higher levels never seen before, and then some.
But when VIX does reach stratospheric heights, it has, in the past, always reverted to the mean (see chart).
In comparison, rising stocks do not all revert to the mean. Historically VIX has dropped to single digits on just a few occasions.
So, the downside for VIX is "known" and this tends to happen gradually.
Of course, past data is not an indicator of future performance, but it is big help!
Thus, expectations regarding reversion to the mean “weigh” on prices (in volatility terms) of the most extreme options on volatility. The result is a rare concave shape for the volatility smile.
Concave IV Smile for UVXY
15 NOV Expiration
Extreme Concavity: CPRI
A more extreme example of a concave volatility smile is Capri Holdings Ltd (CPRI).
Capri Holdings is currently an acquisition target for Tapestry Inc, which has offered to buy CPRI for $57 per share.
The Federal Trade Commission (FTC) sued to stop the deal, and the matter is currently in litigation in Federal Court.[2]
Whatever the outcome, the buyout offer for $57 creates a natural “cap” to the value of CPRI shares.
As a result, the CPRI volatility surface has dramatic concavity in the calls.
Almost every smile bends “downward” for higher strikes, as OMMs can sell these calls for lower risk.
The result is a lower “price” (in volatility terms).
IV Surface for Capri Holdings Ltd (CPRI)
Contango
The final unique feature of the UVXY volatility surface is contango.
Contango is defined as a rising term structure, or higher expected volatility into the future.
Contango is not as rare as concavity or call skew, but it is an important feature of volatility options.
For UVXY, this means that the prices of long dated options are rising into the future, i.e. the price of optionality is rising.
This means that, in general, long dated options are more “expensive” (in vol terms) than shorter dated options.
UVXY is not always in contango, but it often is when future volatility expectations are elevated.
UVXY Volatility Term Structure
$29 Strike
Thanks for reading, and be sure to sign up for your free first month at Volbox.com!
[1] https://www.proshares.com/our-etfs/strategic/uvxy
[2] https://finance.yahoo.com/news/capri-stock-jumps-ftc-hearing-213937696.html