Options: More Caution In Nasdaq Than Other Markets

By Erik Norland

Following the U.S. election and news of two promising COVID-19 vaccines, implied volatility on S&P 500® and Nasdaq-100 options has plunged. In the case of the Nasdaq-100, the VOLQ index of volatility fell from 39.4% on October 29 to 23% by November 18. The QuikStrike tool shows the cost of at-the-money options on the S&P 500 falling from 32.6% to 18.4% over the same period (Figure 1).

Figure 1: Equity index volatility has fallen sharply since just before Election Day

The decline in implied volatility wasn’t limited to the equity market. Implied volatility dropped sharply on U.S. Treasuries as well (Figure 2). It appears that investors have breathed a sigh of relief post-election and in response to vaccine news.

Figure 2: US Treasury implied volatility has also fallen sharply since late October.

With respect to current options market pricing, a few things stand out:

1. Despite the recent decline in investors’ perception of risk, implied volatility remains elevated compared to pre-pandemic norms on equities and 30Y Treasuries (but not on 10Ys).
2. Despite a strong rebound in Q3, economic activity remains far below year-ago levels in the US, Europe, Japan and many other countries (Figure 3).
3. The U.S. budget deficit hit 15.8% of GDP in the year to October 2020 and there is currently no agreement in Washington between a Senate proposal for $750 billion (3.5% of GDP) additional stimulus and a House proposal for $2.2 trillion (around 11% of GDP) Figure 4.
4. EU stimulus efforts, which require unanimity among member nations, are currently being held up by objections from Poland and Hungary.
5. The Nasdaq-100 VOLQ/S&P 500 implied volatility ratio still signals that investors anticipate much greater risk for the Nasdaq-100 than for the S&P 500. 

Figure 3: Q3 showed a sharp rebound but economic activity remains far below normal

Figure 4: Various stimulus proposals could take the deficit to 19-28% of GDP

For much of the summer this year, Nasdaq-100 options cost significantly more than those on the S&P 500, with the ratio of the implied volatility rising as high as 1.6. In the weeks before the election on Nov 3, the Nasdaq-100/S&P 500 volatility ratio came down to just 1.1. Since October 29, implied volatility has fallen proportionately further on the S&P 500 options than on the Nasdaq-100, bringing the ratio back up to around 1.4 (Figure 5).

Figure 5: Investors remain much more concerned about Nasdaq-100 than S&P 500 volatility

It seems clear that investors see Nasdaq-100 and S&P 500 risks differently. This could be because the Nasdaq-100 includes many firms that have performed well despite the pandemic.

The rise in Nasdaq/S&P 500 volatility ratio over the summer had a lot to do with the much stronger upward trend in the Nasdaq-100, whereas the S&P 500 and the Russell 2000 stuck closer to the performance of consumer spending (Figure 6). The strong upward trend in the Nasdaq-100 appears to have made investors nervous about a sharp pullback, which indeed happened in early September. As that pullback was underway, the Nasdaq-100 volatility ratio fell.

Figure 6: Nasdaq-100 decoupled from other indices and from consumer spending

Now with the vaccine news, the S&P 500 and Russell 2000, with high weightings to firms that have been adversely impacted by the pandemic, have rebounded, while the Nasdaq-100 has underperformed. An end to the pandemic could also impact future earnings growth for firms that specialize in online delivery, social networking, virtual internet meetings and the like. This may be why VOLQ in the Nasdaq-100 has not fallen as much as the implied volatility on the S&P 500.

More broadly, we wonder if the decline in implied volatility across equity indices and long-term bonds might prove to be short lived. Given the state of the global economy, the continuing threat of the virus in the US and Europe, the inability of monetary policy alone to support economic activity, and the uncertainty surrounding further EU and U.S. fiscal stimulus, it’s unclear if implied volatility might be at risk of heading higher once again. That said, with positive vaccine news, investors appear to be looking beyond any fall/winter valley towards the next peak in economic activity.

Bottom Line:

• Volatility plunged from October 29 to November 18 on long-term Treasuries and equities
• Implied volatility fell more for the S&P 500 than it did for the Nasdaq-100
• Economic activity remains far below normal in much of the world
• Fiscal stimulus appears stalled in the EU and the US
• Markets seem to be looking past short-term pandemic risks, focusing on longer term
• Investors appear to believe that end to the pandemic is in sight based on positive vaccine news

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