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US Equity Volatility Spikes

· Stock Market,Stock Trading,Coronavirus

US Equity Volatility Spikes

Recently, we have observed a sharp increase in retail investors in the U.S. stock market.

According to Citadel Securities, retail investors make up nearly 25% of the stock market following COVID-driven volatility [2], and much of the new trading activity is concentrated in options contracts. This article aims to explain the rationale for retail investors’ increased involvement in the market, by analyzing the implied and historical volatility of the U.S. stock market.

We will start with two concepts, implied volatility and historical volatility. Implied volatility comes directly from the option premium of the underlying stocks. It is determined by the supply and demand of options and reflects how volatile the market will be in the future.

In other words, it reflects the investors’ expectation of future volatility. For example, higher implied volatility typically means that investors expect the underlying stock will move in either direction sharply in the future.

On the other hand, historical volatility is determined by historical return data. It summarizes how volatile the market was in a certain period. Thus, historical volatility is not forward-looking, but still has lots of implications.

These two volatilities have very important applications in options trading. The historical volatility typically acts as a baseline and the implied volatility represents the option premium. If these two volatilities converge, we could think that the option price is at the fair value given the mean reversion characteristic of volatility.

If the implied volatility is substantially higher than the historical volatility, it implies that the option premium is over-valued. It provides an opportunity for option sellers as they could get a higher premium for selling. More selling will drive down the option price and decrease the implied volatility until it reaches the historical one to achieve equilibrium.

On the other hand, if the implied volatility is dramatically lower than the historical value, it indicates that the option premium is under-valued. It gives option buyers a great chance to buy options given the cheap price. Again, from the perspective of the long-term, the price will be driven up because of higher demand and increased implied volatility to converge the historical value.

Now, let us have a look at the implied volatility and historical volatility during May 2020. This article will use Tesla as an example for analysis. Tesla acts as a ‘benchmark’, leads the significant increase of technology sectors, and has experienced a 400% increase from last year. The following graph shows the 90-day average historical volatility and 90-day average implied volatility for Tesla in May 2020.

Figure 1: Historical Volatility vs. Implied Volatility in May 2020

The orange line indicates the 90-day implied volatility and the grey line stands for the 90-day historical volatility [1]. We can see that the implied volatility is below the historical volatility in early May.

Therefore, it indicates that the option price is under-valued, explaining why investors entered the market this month. The relatively high implied volatility suggests that investors expected a large increase of Tesla stock in the near future.

The following graph shows the historical volatility and implied volatility in May 2019.

Figure 2: Historical Volatility vs. Implied Volatility in May 2019

The blue line indicates the historical volatility and the orange line represents the implied volatility. We can observe that the volatility level is much smaller than that of 2020. The historical and implied volatility are intertwined. So, there is no opportunity here. Then, we could have an implication of the increasing number of retail investors in the option market in 2020, compared to 2019.

Besides the volatility analysis regarding more engagement of retail investors in the market than before, I would also provide some insights into other reasons. The COVID-19 drove up the investors’ expectation of the technology industry, some even arguing that COVID-19 brought a great opportunity for technology firms.

Some retail investors did not use options as a hedging tool, but rather as a leveraging tool. People bought cheap, uut-of-money call options to leverage their position to gain huge profit. Moreover, we could observe momentum and herding effects here. Retail investors tend to buy the stock given it is already at a relatively high level.

Written by Zihan Qiang & Edited by Alexander Fleiss, Xujia Ma, Calvin Ma, Gihyen Eom, Pranshu Gupta & Che Liu

Sources:

[1] Alpha Query.

[2] Ben Winck. Retail traders make up nearly 25% of the stock market following COVID-driven volatility, citadel securities says.

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