Inside Volatility Trading: Sometimes, Smaller Is Better

Inside Volatility Trading: Sometimes, Smaller Is Better

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Based on volume alone, the SPX options clearly have utility.

Over the past few years, options volume continues to move toward short-dated maturities and smaller average contract size.

The inversion in VIX and the significant rise in energy prices reflect the ongoing concern of Russia’s decision to send troops into Ukraine.

primeimages/iStock via Getty Images By Kevin Davitt, Senior Instructor, Cboe Options Institute

Some goin’ east, some goin’ west

Some stand aside to do their very best

Some livin’ big, but the most livin’ small

Peter Tosh – Stop That Train Is Bigger Better?

Humans have an evolutionary desire for “more.” Hunter-gatherer societies were nomadic and constantly searching for sustenance. “More” was associated with a greater probability of survival. For example, a larger buffalo was objectively better because it would yield more meat, more skin – a lot more. From an economic standpoint, more… was better.

While our daily lives look way different than those of the Paleolithic era, our minds are quite similar. We’ve maintained the desire for more, even though it’s often unnecessary. From cars to calories and other creature comforts, more isn’t all it’s cracked up to be. The law of diminishing marginal utility has an inflection point. Basically, there can be negative utility for consumption beyond a specific point. Unlike pizza and paychecks, bigger isn’t always better.

Thinking about the capital markets, is bigger always better? A larger portfolio, greater opportunities, big gains… they all sound great to me. Perhaps it’s my Neanderthal brain at work because it ignores the interconnected relationship between risk and reward. The question is not so straightforward.

Derivative markets, like any other market, have embedded financial risk. The magnitude of risk in derivatives is related to the notional value embedded in the product. That goes for other markets as well, but we don’t typically use the term “notional value” to quantify the risk. In consumer transactions, the price you pay tends to correspond to the degree of risk or responsibility. For example, most might agree there’s more risk in the decision to buy a million-dollar home than there is to rent an apartment for $1,500 per month.

To be clear, we’re talking about financial risk. I could get a Portillo’s Big Beef (dipped, of course) with giardiniera, a large order of fries, and a milkshake for about $15. The risk there is my longer-term health given that bag of takeaway contains around 2,500 calories. That’s one delicious risk, but I digress (and digest). How does this play out in capital markets?

The S&P 500 Index was measuring around 4400 in early March. A standard SPX option has a contract multiplier of 100. Every SPX option affords exposure to 100 units of an index that, at that time, was measuring 4400. So, the notional value (Index value * Contract multiplier) of every SPX option would have been ~$440,000.

On average, nearly 1.6 million SPX options trade daily. Based on volume alone, the SPX options clearly have utility. Generally, they’re used by individuals and institutions with larger portfolio values looking to manage risk. If my portfolio is substantial, diversified, and behaves like the S&P 500 Index, I may choose to use SPX options to hedge my risk or express a market view.

What about the rest of us who might be new to the option markets? What if my portfolio value is smaller? What if someone wants exposure to the S&P 500 Index, but the size of the SPX contract is just too dang large? Appropriate Size Matters

Nanos are here. Cboe is excited to introduce a smaller, simpler index option product.

Nanos work very much like regular index options, but, recalling the relationship between price and risk, a single Nanos contract is much more affordable. Let’s explore why.The underlying index tracks the performance of the S&P 500 Index. However, the Nanos index is 1/10th the size of the standard S&P 500 index.[1] Assume the S&P 500 Index is measuring around 4400. Since the underlying index for Nanos is 1/10th the value of the S&P 500 Index, the Nanos index would be measuring ~440 (4400/10). Translation, it’s much smaller.There’s another key difference between a Nanos contract and a standard index option contract. Nanos have a 1-multiplier whereas all standard equity and index options have a 100-multiplier. Leveraging our example from above with the S&P 500 Index at 4400, Nanos have a more digestible notional value of $440 (Index level * Contract multiplier).An example comparing equivalent (ATM) options will reinforce this important […]

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