Volatility’s Blueprint: How Markets Really Move ft. Mandy Xu & Ed Tom

[00:00:11] Intro

Welcome to U Got Options, an exciting series right here on Top Traders Unplugged, hosted by none other than Cem Karsan, one of the sharpest minds when it comes to understanding what’s really driving market moves beneath the surface.

In this series, Cem brings his deep expertise and unique perspective, honed from years of experience on the trading floor, to candid conversations with some of the brightest minds in the industry. Together, they unpack the shifting tides and underlying forces that move markets and the opportunities they create.

A quick reminder before we dive in, U Got Options is for informational and educational purposes only. None of the discussions you’re about to hear should be considered investment advice. As always, please do your own research and consult with a professional advisor before making any investment decisions.

Now, what makes this series truly special is that it’s recorded right from the heart of the action on the trading floor of the Cboe. That means you might catch a little background buzz. Phones ringing, traders shouting as Cem and his guests unpack real world insights in real time.

We wouldn’t have it any other way because this is as authentic as it gets. And with that, it’s time to hear from those who live and breathe this complex corner of the markets. Here is your host, Cem Karsan.

[00:01:27] Cem

Welcome back to another episode of U Got Options from the Cboe Floor, brought to you by Top Traders Unplugged and Kai Media. Today we get to talk to Mandy Xu and Ed Ed of the Cboe Market Intelligence team.

They get into their new decomposition tool for the VIX, which breaks down some of the inner workings of the VIX and how you use options in the best possible way. They dive into positioning and all of the cool different parts of the market.

Lastly, we talk about history. Where did it all start and where is it going? Enjoy. This is a great one.

(Music)

Hello, welcome back to another U Got Options. Today we’re got Ed Tom and Mandy Xu from the Cboe’s Market Intelligence team. This is going to be a cool one. They have some really cool stuff coming out. I’m really looking forward to chatting about that a little bit later.

But I want to start at the very beginning. Here we are at the Board of Trade and we haven’t had a chance to really talk about how it all started. Where did options come from? Where are we going?

And I just want to kind of lead off with, you know, 1848, we got our first trading here at the Board of Trade. That’s when the Board of Trade was created. So, we go back almost 200 years, 175 years.

And it started really because the railways were here, right in the Midwest by Chicago, right by the Great Lakes and access to the Mississippi. And all of the trade happened here, much like in the Roman times, with the Agora, people, this was the marketplace. This is where people exchange goods.

And sure enough, people would exchange goods. But at some point, the orange growers, needed to come in with the frozen concentrated orange juice, and they had to come to terms about next year so they could prepare themselves. That’s what futures were – trading a future contract.

Eventually people wanted the upside, but they didn’t want the downside. And that’s where insurance and options came in. So, it really started here, right here in this building at the Board of Trade. This is where the options kind of began.

[00:03:42] Mandy

The OG trading floor.

[00:03:43] Cem

The OG, exactly. And then the Cboe came in, and I’ll let you kind of take it from there. How did the Cboe get started?

[00:03:49] Mandy

Yeah, sure, I mean, we started in the smoking room of the Board of Trade and then came here. You’re looking at the original trading floor in 1973.

[00:03:56] Cem

‘73, wow.

[00:03:57] Mandy

I think the evolution in terms of the industry and option trading, it’s just incredible, because when we first started here… I think in the first day, a handful of stocks, we had options, only listed call options, only listed quarterly expirations (if you can believe it). And I believe on the first day I saw something like 900 contracts in total traded here on this floor.

[00:04:17] Cem

900 contracts.

[00:04:19] Mandy

And now they have 18 options exchanges, 40 to 50 million contracts trading on a daily basis. So, they’ve come a long way.

[00:04:25] Cem

So that’s amazing. That’s a long way. And put options didn’t even start in ’73 right?

[00:04:31] Mandy

Exactly, it was a couple years later. And the index options also came a couple of years later. So, it started with single stock options, call options, quarterly options, and now we have everything up to SPX zero day to expense.

[00:04:42] Cem

So hard to imagine. When I started in 1998 on this floor, I remember again, like you said, only quarterly options, every 25 strikes.

[00:04:52] Mandy

Yeah.

[00:04:52] Cem

When the index was trading about 400, you know, a completely different world, paper tickets. It’s come such a long way. Court reporters, oh, my gosh. We used to throw the tickets to the clerks. And then we had paper sheets.

That’s how we made markets, pretty wild, different. You know, I was thinking also about some of the evolution that’s happened. I mean, another thing that people don’t realize is, really until about 1980 or so, options, premiums, if you went and sold put options or call options, that premium could be used to purchase stocks. So, this idea of margining was completely different. There are all kinds of loopholes. They didn’t really close that till the 1980s. My first boss in the business, this guy, John Mulhern, who’s kind of a famous Wall Street legend, got the biggest bonus in Merrill Lynch history, in the early ‘80s, because he was doing exactly that. He would go sell puts, collect a premium and then go invest it in junk bonds. I mean, amazing, right? Crazy to think in this day-and-age…

[00:05:52] Mandy

What could go wrong with that?

[00:05:53.] Cem

But that speaks to the evolution and how far we’ve come, I think. You know, I really like to think about where are we now?

I mean, options are essentially, in my opinion, eating the actual whole underlying asset business. Because options, what they’ve evolved to is every option, a call or put, is a moment on a three dimensional distribution for any asset. And the asset itself is just the expected value of that distribution.

And I think what we want to think about today, and talk about is what is the movement in that distribution, that volatility surface, and how does that affect both the underlying as well as the VIX? Right?

[00:06:35] Mandy

Sure.

[00:06:36] Cem

The Cboe was so good at introducing the VIX and simplifying vol into very simple terms which popularized and helped bring more people in. But I think increasingly, over time, it is a simplification, right? It is a summation in a sense of many things that are going on. And I think really digging under the hood, kind of lifting the curtain and diving into what actually happens in that distribution. How does that affect the VIX, which is really a measure of the width of that distribution, I think will be a really interesting conversation today,

I know you guys are coming out with a product that’ll help us do that. You mind talking a little bit about what that is?

[00:07:11] Mandy

Sure, I’ll set the groundwork, and I’ll pass it off to Ed to talk more about the new analysis that we’re coming out with. But for those who don’t know the VIX index, which everyone follows, but I still get a lot of questions as well, what exactly it measures. So, it’s a measure of expected volatility in the S&P – in simple terms, how much of the S&P is expected to move in the next 30 days? But oftentimes it gets referred to as a fear gate.

I think that’s when you run into trouble because what it is meant to measure is uncertainty, and uncertainty cuts both ways. It’s both downside as well as the upside. Whereas people oftentimes use it only as a measure of downside risk. So hence the name the fear gate.

But oftentimes, you know, we’ll see this market can move a lot to the downside can also go high. And all of that information, I think, sometimes gets lost. And you only use the VIX as a fear gate.

So, what we’ve actually done is broken out what are some of the main drivers underlying the VIX, trying to tease out some of those like directional components: how much of the VIX move is just purely reflection of what the S&P itself is doing, how much is actually additional risk being priced in due to demand for downside hedges, maybe demand for upside calls? All of that can actually really add a lot of complexity, but also a lot of informational value, even for people who don’t trade ops.

[00:08:28] Cem

I completely agree. There’s such a rich… You know, when you look at the distribution of vol, you really start to understand what’s happening underneath the hood of that asset value. You get a real understanding of the risks for that asset.

And I’ll give a quick example. I mean, you could have two stocks from the same industry, same market cap, same exact… If you had no idea, you would think they were the same stock if you just looked at the price. But the reality is if you pull back the option chains, one might be left distributed with a fat left tail. With a fat right tail. I’m sorry. And one might be right distributed with a fat left tail. And the two could have the same expected value, essentially, same market cap, and represent completely different risks.

That’s just in the distribution of them, out in time, and the risks, that could be different, out in time. I think that’s really what’s so amazing about options, why they’re so valuable. They’re flexible. They are much more rich in terms of data and informational value as well.

[00:09:25] Mandy

Yeah, I think not only can you tease out at the implied distribution, as you mentioned. But what is Calga options trading? You can target specifically what part of the distribution you want exposure to.

[00:09:35] Cem

That’s exactly.

[00:09:35] Mandy

If you buy a stock, you’re up and down, you’re kind of exposed all the way. But with an option, say you only want the upside, buy a call option; you only one downside, you only want near term exposure, you only want longer term exposure, you can mix and act.

[00:09:48] Cem

Why take on all the risk of the whole asset. You’re basically taking on every single point on that distribution. When maybe, likely, your informational value that you want to take advantage of is much more specific. And I think that’s the key.

They are so precise, in terms of being able to position exactly for the value that you need with the risk that you need to take with that. And that’s why, I think, it is exactly eating the underlying asset markets, both equities bonds across the board. And that’s why this will continue to be a secular story. I think that’s the case.

So, let’s dive into the decomposition tool a little bit. You want to talk to me about how that works and how you’re thinking about it? I’ll lead it off this way, but obviously the first thing that you mentioned is, you know, when the market moves, we almost always see the VIX go higher, naturally. And what people don’t fully appreciate is if that vol, at the money vol type exposure, is going up, it doesn’t necessarily mean the demand for the volatility surface is going up.

There’s this concept of fixed strike vol where the actual options themselves have an implied volatility and there’s a skewness, particularly in indexes, where you slide down. If you go down in the market then you slide up to a higher volatility, naturally.

And I think that the first of many different parts. I’ll let you go ahead, jump in, Ed, and speak.

[00:11:09] Ed

Yeah, I think that’s really the perfect way to frame it. So basically, the way that we decompose the elements of the VIX is into like five or six different factors. But I would say that you can subdivide those five, six different factors into two major subgroups. The first subgroup is the amount that is already priced in by volatile traders.

So, basically a short way to kind of explain that is, given a certain move in the S&P, what have volatility trades already priced in, as far as the VIX move, per the pre-established skew. And then there’s everything else. And the other component really is the bid for optionality.

And the bid for the optionality can take on many different forms. So, the first thing that we look at is the overall bid for optionality across all strikes. And that usually occurs after a tail event. So, after a tail event, generally traders don’t really understand the implications of that tail event upon economic fundamentals. So, in turn, they don’t want to sell options too cheaply. So, they raise the price of puts, they raise the price of calls. And the way to do that is they lift the entire volatility surface.

[00:12:34] Cem

And I want to dive in here just to simplify it a little bit. If, if you slide down to a higher implied volatility, like you’re saying Ed, you ultimately are at a higher vol, right? But maybe that higher vol is a scenario where the market hasn’t really moved that much. We drop half a percent. Was that more volatile? No, but you’ve naturally slid to a higher implied vol. So, maybe then they will lower the surface back to kind of where it was.

But in the case you’re talking about, where you get a more volatile event or maybe there’s more uncertainty as you slide up to that vol, that vol can then also expand and that’s really more of a tail event. And so, that difference between the expected skew and the actual realized what happened is actually a critical first step.

[00:13:21] Ed

Right.

[00:13:22] Cem

And then to your point, that’s the slide, but then you have other elements. So, what are those?

[00:13:27] Ed

In addition to that lift, what we call parallel shift, and then the increase in optionality for every particular option, then the more subtle effects as well. And the more subtle effects, we can divide into, again, two major groups: bullish views and bearish views.

[00:13:48] Cem

So skew.

[00:13:48] Ed

Skew, exactly right. And the thing is that the skew is divided into two parts: the active part that investors (focused on downside protection) want to be exposed to which is puts, and then those that want to be exposed to the upside which is call.

But there are options that are more likely to occur. Those are the near the money options. And then there’s those that are less likely to occur, the deep-out-of-the-money options. So, those deep out-of-the-money options we call convexity. And so, basically, we subdivide the skew component into those four different parts where we basically have near-the-money puts and calls and the out-of-the-money puts and calls.

[00:14:39] Cem

Yep. So, to summarize, we essentially have a slide which, What do you guys call that in your decomposition?

[00:14:45] Mandy

The expected move.

[00:14:46] Cem

The expected move. And again, you have a volatility surface. There’s skew, so, you slide down. Let’s give an example here.

Let’s say (I’m going to make up these numbers), let’s say we’re 2% out-of-the-money at a 30 day period. Let’s say, the at-the-money is a 10 vol and down, let’s say it’s 15. Okay? Let’s say we slide to that 15 vol.

Now, the question is, is that at-the-money vol going to be sustained at that 15 or is it going to go up or down? And that’s the second part; how much have we shifted off the expected?

And then there is skew. How much are the out-of-the-money puts, and out-of-the-money calls moving relative to one another? Probably at one standard deviation or so. What do you guys look at?

0:15:34 Ed

Typically it’s one standard.

0:15:34 Cem

One standard deviation, you’re looking at how much higher is the downside option being priced versus the upside? And then do you call the last one kurtosis or what do you call?

[00:15:40] Ed

Yeah, so back to the convexity, same idea.

[00:15:42] Cem

Very standard. There’s a reason I know these. Yeah, I’ve been trading… You know, a lot of these models that market makers use are based on the similar structure and that’s really measuring the tail, the kind of curvature, and how steep that skew convexity is. And so, if you break it down into these components, you can really begin to see how much is constituting the VIX, causing the VIX to go higher or lower.

[00:16:06] Mandy

The reason I think we break it down is oftentimes, well, not oftentimes, but sometimes the VIX can be going up because of demand for the upside. All else equal, someone comes in and buys a large amount of S&P up-tic hold, that’s going to drive the VIX higher. And that’s the counterintuitive move.

So about 20% of the time the VIX moves in the opposite direction of the S&P. And people often get confused as to why that is. And when we do the decompose composition, you’ll see, it could be the surface actually going down. It could be actually more purchase where less purchase upside closer. So, there are a lot of factors to disentangle. But that’s why, you know, just thinking of the VIX as a fear gate, it’s fear. Sometimes it’s driven by fear of downside, sometimes it’s driven by fear of missing out on the upside. That directional signal is really valuable.

[00:16:51] Cem

I totally agree. And actually, to that upside note, I’d be curious if you know the numbers. You probably don’t exactly. We can always follow up. But what percentage of those 20%, that that go the opposite way, happen to the upside? I’m guessing it’s actually more than half of them.

00:17:10 Mandy

It’s about half.

00:17:10 Cem

About half, somewhere around there. That makes sense because a lot of times you naturally, not only do you slide to a higher vol on the downside, you slide to a lower vol on the upside. And often a rally can get going to a point where the implied volatility has really hit a floor.

And that floor is, you know, as we slide to a lower vol, it gets too cheap, and then they end up raising the VIX into rally. And often that’s actually a very good indicator for when vol is becoming more unpinned and there’s more risk of a downside kind of occurrence, actually. A really great indicator for those people who look at these.

So, these things can be very valuable. There’s a ton of informational value, as you mentioned. And again, understanding the difference between the VIX and the actual demand for vol in general, I think, is really important. That fear index idea can be not absolutely correct at all times.

[00:18:02] Mandy

And I think that can help disentangle, sometimes, why the VIX moves a lot for a given S&P move. Sometimes it doesn’t move a lot at all, or it doesn’t move much. So, for example, in 2022 we had a very protracted long, deep 20% sell off in the S&P. The VIX didn’t really do much. Versus, over the past year, we’ve had some big S&P moves, but even bigger vol moves. So, when you disentangle, you’ll see what is in the driver behind that.

[00:18:28] Cem

And if you think about it, like, what is fear? Fear is when people have to go buy and raise. The cost of insurance. As you were saying, it’s a tail event and the insurance premiums go up or down and a lack of fear. And I really think that differentiation is about what’s happening to that surface. Is it going down or going up? Well, it’s expectations and I think that’s critical.

So, I’d love to kind of walk through, now that we’ve kind of laid the groundwork of a VIX decomposition tool, a little bit of history. And talk through some of these examples when maybe the surface moved in different ways, and why that might happen, and Describe also how this might be useful to traders out there other than just understanding better the products.

We’ve done a study actually of the last 10 years of vol moves. When I say vol moves, actual bigger market moves and how they played out. And it’s a really interesting phenomenon.

I actually referred to it a little bit with Benn Eifert, when we were doing a episode here, which is really starting on August 15th. The first real decline, I would say, since ‘09.

We had a little one in ‘11, but for the most part it was the beginning of kind of the more modern era where volatility is kind of more actively used. And we had a big yuan devaluation in August 2015, for those that remember.

And it was a time when screens went dark like you could not access markets. Vol exploded, implied vol, that surface exploded higher. And skew exploded higher. And that was the first one we saw like that really since ‘08. I mean it would have been a long, long time.

But it was very options driven. And part of it was because we had not had an event for so long that vol selling had been so profitable that the actual positioning in markets was very short skew and implied volatility. And it really drove a margins event, if you will, like a real skew, like people had to cover.

But soon afterwards, February of ‘16, just six months after, we had an actual decline that was much, much more placid, but actually a deeper cut. That first decline was only 9%, the August 15th. February ‘16 was 12.5% – the first decline of more than 10% that we had seen since ‘09.

And that’s very counterintuitive, Right? Because you would think a bigger decline would be more stressful. But what actually happened there is skew collapsed, and implied volatility collapsed, and I’m sure if people go look at the VIX decomposition tool, they’ll be able to look at these two and see two very different outcomes.

[00:21:11] Mandy

Yeah. So, I would say in addition, we have a published report on the VIX decomposition and the framework, but we also have, on our website, posted sample decompositions of some of the big VIX moves of the past, I think 25 plus years.

[00:21:23] Cem

Oh wow.

[00:21:24] Mandy

So, definitely viewers can go and take a look. But I think you bring up a really good point which is that, you know, why is it sometimes vol overreacts and sometimes it underreacts, and positioning certainly can play a part in that. I think it also depends on the catalyst. Because what really drives volatility is when the unexpected happens – the unknown unknown hits the market.

That’s when you get traders starting to panic, really lifting kind of that price of optionality across the board. That’s what happened in August of 2015 with the China slowdown. It was the first time that people really started considering like a hard landing in China, what that means for global growth.

By the time February came around we’ve been talking about that risk for six months. Yes, you get incrementally worse data out of China, but at that point it was a new news. You had time to position your portfolio or maybe delever parts of the portfolio. Therefore, you don’t really have that same effect going into February.

[00:22:17] Cem

Absolutely. I think that I generally break it down into two mental structures. One, everybody’s fighting the last war. That’s kind of what you’re talking about, right? People have just seen it happen, they deleverage there, they had time, they were prepared. That’s definitely the case.

And by the way, I’ll kind of walk through the history a little bit more. But what you see is a sine curve of vol performs, skew performs, and then the next time, you know, six months, a year, whenever it happens next, you have almost the exact opposite, But importantly, people are fighting that last war. That’s part of it.

But actually, there’s a structural supply and demand effect where if there’s a margin call, and if people get forced out of shorts, guess what? Funds that are selling vol enter, they get washed out to sea there. They have to cover, and they probably don’t have capital coming forward.

Meanwhile, the winners, whoever just got paid out with convexity (and not to mention everybody who wasn’t hedged), next time is like, oh, I better be hedged. And they send them money. So, there’s actually a supply and demand dynamic that is natural, that that you’re going to get kind of based on positioning opposite.

[00:23:18] Mandy

I mean hedging demand certainly comes in a waves.

[00:23:21] Cem

Definitely, yeah, 100% and I’ll just real quick kind of walk through that. So, after February 16th and poor performance evolved, people are like why would I buy puts? I’ve owned them for this exact moment.

We have got the biggest decline since ‘09 and it doesn’t even pay off. And that led to a ton of vol selling, which there were new products that came out when Iron Condor was happening in these pits back then, XIV.

All of that selling, then, begot vol compression. It seemed like a crazy winning trade. Like how could this go wrong? Even in the biggest decline, it wasn’t that bad. We could handle it. Which led to the Volpocalypse or Volmageddon, February 2018. And that one went longer. It wasn’t just six months. And part of that was because of the level of vol compression that was happening.

By the way, I’ll note and we’ll get back to this with reflexivity, but 2017 was the lowest realized and implied volatility in 125 years of history. Not just a record, a complete outlier. And we’re going to get to that in a little bit here. But there’s actually, these are not just measures, mind you, of what’s happening in the underlying market. There is a reflexive effect. And they’re integrally tied.

But, fast forward Volpocalypse. Well, after that again, all the shorts got washed to sea. Of all the longs made a tremendous amount of money. That decline though was only 9%. Again, a short, quick, big move, kind of like that 2015 move. But it was very painful. One of the most painful per move ever in history. Which led to October, November, December 2018, which, by the way, skew got pretty hit during that time. Vol underperformed. But again, notice it was a 19% decline. It was a much bigger decline.

And ironically when hedges aren’t working for institutions, it can lead to a deeper cut. But again, everybody who held those hedges was like, it’s biggest decline since’ 09, again. It didn’t even help me. Why am I doing this? Selling vol, selling vol, selling vol. Enter Covid. And Covid was, from Feb OpEx, literally the day after Feb OpEx to March OpEx, a massive one month decline, very centered on March. I mean obviously it was a big macro event.

But the supply of vol and the hedging issues definitely exacerbated some of that move and made it steeper and a big vol event, which I think was particularly interesting. And then 2022 is the next one of the biggest, you know, 27% decline, but very slow, market down, vol down, skew down.

Which brings us, probably, to the most recent thing that I’d love to talk about, which is the most recent two, which are kind of interesting because they both involve that. And they’re separated by, this is August, 2024, and April 2025. But I think you highlighted something very, very interesting to me, which is how different those two vol events were. Maybe you can dive into August 2024 and April 25, Liberation Day. And I don’t know, Ed, you want to take this or Mandy?

[00:26:42] Ed

Sure, I’ll take that. Yeah. And basically, I think I want to start off with the similarities between the two.

[00:26:46] Cem

Yeah, let’s do it, absolutely.

[00:26:47] Ed

So, in both cases, if you look at S&P spot, in both cases, basically, due to the event, the S&P declined 3% to 5%. And in both cases, prior to the catalyst, the VIX was trading in the low 20s. And then in both cases, in response to the shock, the VIX doubled to the mid to low 40s. So, from a statistical point of view, it looks like the two events are very similar.

But when we run the decomposition, what we found was that, looking at the August 5 event, what drove the increase in VIX was primarily a bid for downside protection, which we kind of think of it as the classical reaction to a tail event.

[00:27:35] Cem

Like our sign curve, right? After ‘22, that’s the type of decline you usually get. And that makes a ton of sense.

[00:27:40] Ed

Exactly. So, up to about 10 points of the VIX was due to a bid for downside. And to fund that downside protection, people sold upside. But if you look at Liberation Day, you saw basically, like a very different reaction. So, what caused a large rise in the VIX was actually a bid for upside convexity.

[00:28:03] Cem

That’s fascinating.

[00:28:05] Ed

Yeah. So basically, people were positioning for an upside rally in the S&P. And if you recall, after that event, we actually did have about a 15% increase in S&P over the following weeks.

[00:28:23] Cem

And I can’t help but wonder how much of that was, again, reflexive. Part of that V bottom and that quick rally was because of the positioning, market makers and dealers essentially being short those calls, because institutions are buying so much. That’s why that…

[00:28:39] Mandy

Yeah. So, I think positioning is certainly one part of it. I also think, in the April case, part of what was so unusual or interesting about it, I think, is the catalyst behind it. The Trump’s trade war, and now everyone kind of knows the term TACO, but certainly, at least in the options market, you can kind of see that being priced in. It’s really unusual for the S&P to be down 6% in a day and there not to be any incremental pricing higher of those downside puts.

So, people, even in the depth of the April sell-off this year, believe that there was a Trump put out in the market. Therefore, you didn’t need to buy additional downside protection and in fact believe that he was going to reverse course, and we’re positioning for the upside. And of course, a couple of days later, that’s exactly what happened.

And you know, to Ed’s point, the biggest vol move, in April, was to the upside. That was very interesting.

[00:29:27] Cem

Yeah. And I think we’re implicitly saying this through this conversation, but I want to be a little bit more explicit. Watching what’s happening to the surface can tell you a lot about positioning itself.

[00:29:38] Mandy

100%.

[00:29:39] Cem

And this world is becoming increasingly, directional trading and even vol trading is increasingly about positioning. Who is positioned how and why? Obviously, markets are supply and demand. And if the market’s positioned a very big way one way, it can very well lead to, you know, that can be supply or demand and weight. So, people often ask, how do we know what positioning is? I mean, yes, you can look at trades and you can track them, but price doesn’t lie either. And if you can really understand the volatility surface, that can really help you get a sense.

[00:30:09] Mandy

Yeah, to that point, the example that I like to use is like 2022 compared to, say, last August. So, in 2022, when the market was selling off, we had, I think in the course of the year, eight times that S&P sold off more than 3% in a day. So, pretty big moves. On average, VIX went up 4 points. Last August, S&P sold off 3%. VIX up 15 points. 15 points day over day, intraday was even higher.

So that kind of tells you that in 2022 people were already positioned for higher interest rates, they were already positioned for Fed tightening. People were deleveraging throughout the year, moving to cash. Once you move your portfolio to cash, you sell stocks. You don’t need a hedge.

There’s no demand for optionality. And that’s why the VIX didn’t really move. Last August, what happened, the yen carry trade blow-up kind of came out of nowhere. Yes, there was already a lot of focus on what was happening in Japan. And again, but on that particular day or that weekend, that came out of nowhere. That was unexpected.

We did see panic in the market. We did see people coming in to buy hedges, like Ed mentioned. And that was what was driving that overreaction in the VIX.

And really like why this matters, beyond just like positioning and kind of getting clues on where the market is going, is when you think about from a hedging perspective the performance of vol relative to what the spot or the S&P is going to do, it’s a key question you have to answer when thinking about which instrument do you use to hedge, Do you buy S&P puts or do you buy VIX call? The two classic instruments people use to hide what is going to perform better in the next prices. And that spot, that dynamic, between what VIX is going to do and what the S&P is doing, is really key to kind of determining which is better.

[00:31:50] Cem

Not to mention what strikes to buy in the SPX or in the VIX. It’s critical because the speed of the move and the relationship to vol is 100% going to inform how to hedge. Again, people often say, and this is why the VIX decomposition tool is so valuable, often say well just buy vol or sell vol.

Well, vol isn’t one thing and that’s why someone was saying. Vol is a distribution of outcomes and understanding which parts of the distribution to own is so critical to getting that hedging right.

I’d like dive a little bit more into the reflexive effects because I really think it’s so important. So many people trade the underlying instruments and are trying to hedge the underlying instruments. And so, understanding how positioning, on the option side, can be really a great signal and so informative for the underlying.

I think because the world has generally started, like Wall Street started, with the assets themselves. Most people think that options or vol, broadly, are somehow a reflection of the underlying movement. Everybody talks about it that way. And yes, that’s part of it.

But I think it’s so critical to highlight that it’s now, as I was highlighting, the underlying distribution you could argue is now the three-dimensional dog. It is the three-dimensional market and that expected value which is the asset price. So, there is a push pull.

There’s a very reflexive important effect of what is happening to that distribution where it’s not trading and how does that affect the underlying stuff? And so, when vol becomes so compressed and there’s so much demand for puts, so much positioning inputs, for example, the way this tends to work is that if the market’s going down, people have hedges, if those hedges aren’t performing, they need to capture that as much as they can in order to capture some type of hedge against their underlying.

And what that does is if dealers keep getting long, and long this vol, they’re going to lower their volatility, as the decomposition tool will show. And they’ll lower the skew, as the decomposition will show. And if somebody has to warehouse that rest, the dealers have to. The dealers will ultimately have to hedge that volatility. They’ll have to buy when the market goes down. And so, when it goes up, that reflexively slows down the decline. And that’s so critical. Understanding those reflexive effects. Whereas during the state of all Volpocalypse, it’s the exact opposite.

The gamma effects of moving into these people being short, that means they have to sell stock into it. As the market goes down, they need to sell. As the market goes up, they need to buy. And that unpinning of vol can create dramatic moves. So, I think people really need to flip this idea on the head that that the options that are traded here, and that options in general, are a derivative or a kind of a secondary reflection of an underlying. I know this is different. It’s going to break some brains, right?

But the reality is, increasingly, as volume is growing here, and it becomes a more central part of the market, and better technologies and we said that are hitting, really, a tipping point. I think you really need to start flipping that and thinking, okay, how is the distribution and the trading and the positioning affecting that?

Any thoughts on any of that?

[00:35:06] Mandy

Yeah. So, I think that what we described in terms of the hedging, the positioning certainly is important. I think the debate or the question is just how big is that? I think a lot of times people, reflexively, kind of point to dealer positioning as a reason why the market’s moving one way or the other. And we think it’s one factor. I don’t think it’s necessarily the dominant factor right now.

And a lot of times, you know, the way that people get to this dealer positioning because keep in mind that it’s actually very difficult.

[00:35:36] Cem

Incredibly.

[00:35:36] Mandy

Yeah. So, there are a lot of assumptions. So that’s why it’s a lot of assumptions that are based on that. And maybe I’ll just use the example of SPX0DTE because that’s the one that’s been in the press a lot where people talk about positioning. And they’re focusing a lot of times on the gross volume number. Like look, 2 million contracts are trading in zero-day options every single day, one trillion notional. You know, how could this not be moving the market? But as we all know, what really drives positioning is the net buys and sells, right? How much net.

The net positioning is what market makers and dealers have to hedge. So, it matters how balanced that flow is. Now in longer dated options I would say most people are using the head. But an extremely short day like zero DTE options we actually get very balanced buys and sells, puts and calls.

So, the net amount you actually have to head tends to be actually a lot lower than what maybe the headline number would suggest just looking at the gross motion. But certainly, I think positioning is important. I think sometimes it gets a little bit overused as a reason why market’s moving one way or the other.

[00:36:38] Cem

But just like anything new, it’s scary, right? People get too concerned. I agree about that. But, like we said, it’s all interconnected, right?

If you’re a market maker, you’re trading everything versus everything, and there’s a natural mathematical connection between them all. So, any positioning on one side will definitely affect the other.

The one thing I’ll highlight is on the market maker net positioning, market makers tend to also want to be flat. So, that’s a lot of the reason that is flat. Now, the point is all parts of the distribution matter, they all have effects. It’s just the extent and to what scale I think.

[00:37:12] Mandy

There are certainly moves that are pure positioning driven like Volmageddon, as we talked about, just how big the short vol trade had gotten, especially in the big VIX ETPs. And you can kind of tell.

Actually, one of the indicators that we came out with fairly recently, to help investors tell when a vol move is fundamentally driven versus pure technical or positioning driven, is something called dispersion – DSPX. So, DSPX or dispersion, at its core, is a measure of single stock volatility which tends to be driven mostly by fundamentals.

Now when you have a VIX spike, as you did in Volmageddon, when VIX went up, but DSPX actually went down, that told you that this was a pure technical move in the market. It was not about a single stock fundamentals. Versus, say, in 2022, you actually had both VIX going up and DSPX going up, telling you that, yes, there’s systemic like market wide risk, but also earnings and fundamental risk were also increasing because of Covid. So, using it like a toolbox of, you know, VIX, DSPX, a couple of different indicators can really help paint, I think, a better picture of what exactly is driving the market lower and volatility higher.

[00:38:25] Cem

I completely agree. Actually, I mentioned it before. But let’s circle back, 2017, right? We had the lowest realizing and implied volatility in 125 years – a complete outlier.

[00:38:35] Mandy

Yeah.

[00:38:35] Cem

If you look at kind of a scatter plot of all those years, and the question is, when you see a dramatic outlier, like, why is that? And a lot of it was because (and there’s no way to prove this to be clear, but I was standing in these pits and I was one of the biggest market makers in here) a lot of it was because there was this massive vol. And we would pin exact strikes. So, anecdotally, I can tell you there is this massive reflexive effect. But what that drove, interestingly, is dispersion.

We saw, at the same time, and we kind of noticed (you can take the data and understand this), we also, at the same time we saw an outlier in terms of underlying vol of the index, we saw a historic correlation breakdown. We saw a 25% lower correlation between the constituents of the S&P 500 than any other time in history – again, two massive outliers.

Those two things, that’s not coincidence. Those two things are intrinsically tied, but not in the way people think. People, again, take a first order asset view and they say, oh, well, things just broke down. There must have been a macro reality that things were moving away from each other and that’s what lowered the implied volatility. When the truth was greatly the opposite, that the index itself was relatively pinned due to vol supply. And, as you mentioned, underlying stocks, which were not the core of vol senders, still experienced idiosyncratic risk.

[00:39:52] Mandy

Oh, that’s tons of idiosyncratic risk.

[00:39:54] Cem

And if you look at those single stocks and you look at the historic scatterplot of their volatility, it’s actually within that one standard deviation. So, the underlying stocks experienced a similar volatility to history because they weren’t being pinned by the vol, but the index did. And that breakdown (and this is counterintuitive) actually drove things away from each other.

[00:40:16] Mandy

Yeah, so, that what happened in 2017 is actually very similar to what was happening in 2022 up until fairly recently, where you had, you know, a vol compression at the index level, but single stock volatility was actually average or around average. It was not very low. And actually more recently, single stock volatility has been very high. And what has kind of compressed the index volatility is the fact that things are moving in different directions.

In 2017, if you recall, that was on the back of the Trump tax bill, the first tax bill. A lot of people were picking out the winners and losers. More recently in 2022, 2023, it was higher inflation and higher rate picking out winners and losers of that.

[00:40:55] Cem

I’ll jump in. Everybody points to the macro reasons. I do think those are relevant. I’m not saying it’s irrelevant, they both affect each other. But I also want to highlight that it’s also supply and demand on the actual vol products. So, they’re both interacting together in a very powerful way.

If you look at dispersion historically, dispersion is actually, you know, a lot lower than it has been since 2005. Really a lot of that is the growth here in vol. It’s also things like structured products, and ETF issuance, and the supply of vol.

And again, it’s not one thing. It’s also the macro. I’m not saying that’s not the case. But I think it’s a healthy debate and conversation that needs to be had, that both things are driving, simultaneously, a significant increase in dispersion and its efficacy. Again, idiosyncratic risk is closer within the realm of historic norms.

Things go up like, you know, Nvidia beats earnings are going to go up, but guess what? If the index is going nowhere because of vol supply, something else has to go down. And that’s what a correlation breakdown looks like.

There’s a natural arbitrage effect of things moving away from each other as index vol as well. And most of these structural products like most ETFs are here in the S&P 500 and that’s really what drives it, I think a lot of it.

[00:42:10] Mandy

The macro world is also.

[00:42:12] Cem

No, no, they’re both important unequivocally. Just like anything. It’s never black or white, but it’s gray. And I think that’s important.

Well, let’s talk a little bit more about zero DTE. Like, I mean you can’t, you can’t have a conversation with supermarket intelligence without driving to zero DTE. Where are we now in terms of volume percentages? What does that look like in terms of percentage total volume growth? Talk to me a little bit about it.

[00:42:38] Mandy

Yeah, you definitely bring up a very hot topic, if you will. So, zero DT options are now trading on average about 2 million contracts a day. It’s about 60% of overall SPX.

[00:42:49] Cem

60%.

[00:42:50] Mandy

60% and that’s up I think, you know, in 2020 it was up 12%. So, it’s grown significantly since then. And it’s really grown, I think, on the backs of two factors.

So, one is broader access and increased adoption. So, a lot of retail investors coming in and understanding options trading. We talked about like loads of options trading since the pandemic. That’s been huge. I mean I would say in 2020, 2021, most of that growth was actually focused at the single stock level. People coming in to trade Apple or GameStop (if you remember calls).

But since 2022, actually, a lot of the growth has come from the index side and with the zero day to export options. Cboe introduced the Tuesday/Thursday, back in 2022, that completed, if you will, the set of daily expirations available. And that allowed investors to really kind of increase the type of strategies that they can trade using zero DTE options.

So one is, I would say, increased adoption and the second is just diversity of use cases. I would say the biggest difference when it comes to retail trading of SPX0DCE options, say, what they’re doing is on a single stock level is at the single stock level most of the trading is for directional leverage.

At the index level we actually see a balance between yes, a lot of people are using these calls inputs for directional exposure because they’re so cheap, and you could get incredible leverage to the underlying SMC move. But actually, a lot of people are using these options for income.

So systematically selling put spreads, call spreads, I-condors, butterflies, to collect yield. That’s been a very popular trade, and I think that surprises a lot of people.

[00:44:23] Cem

I want to dive into this because I think this is so important and I’m going to, again, circle it back to something you were saying before. In 2020, when we were trading options, everybody saw this spike. And it was attributable, in the media, to the speculation and the attendees; people getting the money, and sitting at home. And this is the time of GME and all the speculation. I was very clear, four years ago, that this is (much like a lot of things like the work from home), this is just an acceleration of a trend that’s been here and it’s actually really a tipping point.

And what I mean by that, there’s this concept (as you guys know) in technology where, if there is a superior technology, it doesn’t get adopted right away because things are hard to access, hard to use. You need something like network effects. You need more expirations in this case, smaller strike increments. You need to go from a 250 multiplier, to 100, to 50, to 10, to 1, to 0.1. You need access to Robinhood, and TD Ameritrade, and any number trading zero commissions. You need education. That’s what we’re doing here, right?

You need more people to get involved. But the more people that get involved, guess what? The more liquidity there is, the more network effects there are, and the more volume that people can more comfortably execute and manage risk. So, this whole infrastructure has been building, really, since way before, from that very beginning, 1848. Slowly, but it builds exponentially.

And the thing is we really hit a tipping point, I feel. I feel like Covid was an accelerant. And I really do believe it’s accelerated also by the macro environment, as you mentioned. Because, in a world where things are consistently going up, and the Fed has dominance, and it’s a very one dimensional world, markets are much more one directional.

You can be long stocks, and long bonds, and kind of sleep better at night. Yes, you may have some volatility event but the more markets become, you know, tariffs, they become more disjointed. Then non-correlation matters more, risk management matters more, and understanding how to position in a more no-correlated way and thinking about risk matters more. And so, as that’s happening, we’re also hitting this tipping point in adoption. I really think there’s a reason that the Cboe, the volumes are accelerating, but the use cases are accelerating.

I only expect that to be happening not just for the next 10 years, but like I said, I really genuinely believe that this will eat the asset market itself. It is the three dimensional dog. And so, I really, really believe that’s where we’re going ultimately. And ultimately this is just one more step towards that direction.

[00:47:02] Mandy

Yeah, I think two points, like people understanding that you can use options not just for the directional leverage, but for many other reasons. And then to isolate what part of distribution you want access to, for income, for many different reasons. This is why we’ve taken this next higher intuitive volume. Because if you look at the single stock option volume in ‘22, when the market went down, single stock option volume actually went down that year because if you’re mostly buying upside calls, and markets down 20%, you’re probably out of capital. You know, you probably lost a lot of money.

But if you’re using options for not just directional but for systematic yield harvesting, that’s more sustainable. And I think that’s what’s been surprising about the zero DTE. From the very beginning people said, oh, this is just speculative. This is just another iteration of the mean stock era. But since 2022 we’ve gone through an extended bear market. We’ve gone through many vol shocks, right?

So, the August one of last year and, and April one of this year when VIX went up to 65. We’ve gone through days when S&P moved 10% in a single day. And yet the zero DTE flow continues to grow. It tells you that it’s not just one dominant trade or one direction. It’s many different things and how balanced it is.

[00:48:14] Cem

Much like the distribution, you can bet on any outcome in the market. That’s the key, I think. We talk about volatility and the VIX and those are critical. And we’ve always, the Cboe has at its core had a risk management kind of focus. We can call the conference, the Risk Management Conference, Right? It’s been about hedging.

But I think what the world is waking up to is options are great for not just hedging. They’re not just great for, you know, offsetting a long exposure. They’re great for positioning at large with much more precise risk/reward metrics in any direction. And that’s why I think zero DTE is very popular. That’s why the single list stocks are popular. And that’s where a lot of the growth is coming from. Because essentially the 99% of the rest of the market is moving towards a better way to position.

[00:49:00] Mandy

That for you, to illustrate what you said, if you look at SPX options, non-zero DTE, it’s more tilted towards put could be used for hedging. For zero DTE it’s one for one versus yeah, it’s extremely balanced and it’s balanced regardless of what the market is doing, regardless of what vol is doing. It’s always consistently one-to-one. To the point that people are discovering the many different ways they can create this option.

[00:49:22] Cem

And I think the popularity of zero DTE, not that the other parts of the distribution, the other explorations aren’t trading more, because they are as well, but the dramatic increase in zero DTE, I think, as well as single stock are really a function of… It’s simplifying in a bit some of the things we’re talking about.

I think that when you look at the VIX, you have to worry about implied vol. is SKU happening? But if you’re dealing with a one-day option, it’s where is it going to end today?

It’s really a break-even story and I think that’s part of that positioning that’s made it so popular. But again, to your point, I think it definitely gets overdone that zero DTE is somehow some systemic issue – definitely not. It is definitely though important to the market structure and critical to that that ecosystem.

I would argue that, as zero DTE grows, it’ll actually create much more stability in the sense that the optioning flexibility of positioning will be dramatic.

[00:50:13] Mandy

One of the things we’ve heard from market makers, actually, is that the liquidity and all the volume in zero DTE actually helps them manage and hedge their books, and actually being able to provide more liquidity in the back end of the curve for longer dated options. So, there is that fact.

[00:50:29] Cem

I couldn’t agree more.

All right, well, last of all, how do we use options? We kind of talked about, you know, what do you think the optimal ways to use the VIX are to manage vol, to position more broadly? I mean we talked about, obviously, position wise, you could take any part of the distribution. But let’s be more specific. What are some of the better ways to, to hedge and use options out there?

[00:50:50] Ed

So, basically, I think that part of the elements that one needs to consider is how much premium do you want to expense? And a lot of times what smarter option players do is they basically target the portion of the distribution that they actually want. They buy that and they sell the other parts that they don’t want. So basically, they fund their trade by selling the improbable parts of the distribution.

[00:51:22] Cem

I couldn’t agree more. So, you want to model your own distribution. What do I think is likely to happen in general? Not just up/down, but what are the probabilities of different outcomes? And if you find parts that are expensive, you can use those to fund the parts that you think are essentially cheap. I couldn’t agree more.

That’s, that’s the key, is understanding what your probability distribution of outcomes are and then pairing that with the positioning which you could also get some information on your decomposition tool.

Wonderful chatting with you guys today, thank you. What a wonderful rich conversation.

00:51:53 Mandy

Yeah, my pleasure.

00:51:54 Cem

Where should people go if they want to go see the decomposition tool? When will they get more? Give us a little insight.

[00:52:00] Mandy

So, the white paper or the report that we have outlining the framework and the intuition behind the framework is available on our website, as well as some historical snapshots of big vol moves in the market and running that decomposition to kind of give you further color. Where we would like eventually to be is actually provide this decomposition in real time.

And so, we are developing a tool, hopefully it will be out in October, but please check back, where you can actually come and run the decomposition on a daily basis and potentially even intra-day basis to look at what exactly is driving the VIX and get some of that insight into the positioning. Is it puts as a calls, is it downside? And that that we hope to be available sometime in October.

[00:52:42] Cem

Yeah. And that’s essentially providing insights that you would otherwise have needed, you know, somebody like me or somebody who’s an expert in these spaces to understand. That’s incredibly valuable. Is there going to be historic data too?

[00:52:53] Mandy

Yeah, there will be some historical data available as well.

[00:52:56] Cem

Okay, amazing, amazing. Thank you guys. Wonderful conversation.

[00:53:04] Ending

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