Why Semiconductor Volatility Diverges From the Index

SPEAKER_1 (0:00)

Joining me now to discuss trends in volatility is Zed Francis, CIO and co-founder at Convexitas. Zed, always great to have you in.

You sent over a pretty decently long list of things investors are worried about. Now, none of them shocking, but you know, September seasonality, the midterm year effect, long-term treasury yields, hyperscaler credit spreads, geopolitics, of course, top of mind right now. But you say that you just don't see those fears reflected right now in US equity options, why not?

Zed Francis (0:27)

Yeah, the number one theme for the month of August when it comes to volatility was just volatility getting erased from the market. I mean, we've obviously reasonably range-bound as a slightly up month, but implied volatility, what's in the price of the options you're buying or selling out in the future, absolutely collapse. So, and that's single names, index, everything. So, index volatility is essentially at two-year lows. And so, I think with the backdrop of we have all these wallowary type of issues, but it's not being reflected, and people are essentially not hedging portfolios using options at this moment in time.

SPEAKER_1 (1:05)

So, does that tell you that investors are comfortable with downside risk, or are they just choosing to express it somewhere else?

Zed Francis (1:13)

Yeah, I think there's kind of three categories of investors, of which the book ends where it may war. So, retail investors are heavily invested in markets and don't seem very fearful. They're not using options as tools. They're pretty heavily invested. Then you have CTAs that because volatility has been so low, they've actually accumulated a lot of risk, but they don't even ever really use options. They're just, we're following the rules like this is what we're doing. But then you have the third one, which is institutional investors throw hedge funds in there, pensions, things along those lines. Those folks are pretty light risk. So, they're really kind of bearishly positions by just owning less equities than their benchmarks, or where they normally would historically. So, they kind of don't need to hedge. They're ready to put their bet on by just essentially selling. So, I think with that combination, it's kind of how we've gotten here, where volatility is incredibly low, but at the same time, the market is reasonably balanced.

SPEAKER_1 (2:08)

The thing that really stuck out to me is the divergence you highlighted between the index volatility and single stock volatility. Why has volatility in the single names gotten so much higher in individual terms, while the index still seems relatively calm?

Zed Francis (2:23)

Yeah. It's been a real theme of color the last three years, where single names are moving a decent amount, but essentially stocks are diversifying themselves. Every single day, they're going in different directions, and so the index looks muted even though underneath the hood things are moving quite aggressively. Then we had Q2 that was pretty specific. It was pretty specific to the semiconductor sector, which became almost 20 percent of the S&P 500, so a very meaningful sector, but those names had astronomically elevated volatility. I mean, their volatility, even though obviously the stocks were doing well for the most part, were back to tariff tantrum, COVID type levels, like really extreme volatility, so that was pulling everything higher for the single names. But we got that release, the pressure at the end of July when one hedge fund assumed the risk of another hedge fund, and ever since that period of time, volatility in single names is finally retracting.

Again, index is retracting too, but single names have been really dramatic over the last six weeks.

SPEAKER_1 (3:27)

If we continue to have index volatility stay subdued, we continue to see the single stock volatility fall, does that then make an argument for a continued move higher in equities?

Zed Francis (3:37)

Yeah. I mean, I think it doesn't really tell you a whole heck of a lot about direction. What I find really interesting is essentially correlation. So what S&P 500 index, the main one everybody obviously looks at, is it's a summation of all the constituents weighted volatility, and then you put a correlation assumption to basically get to index volatility.

Correlations have been incredibly low, and correlation assumptions in those options, forward correlation expectations have also been incredibly low. Now, they got really stretched when single names were really elevated, index was low. The only way the math, basically, mass is you have to say like correlation is essentially zero. Now, with single name volatility falling, you're getting a little pick up in correlation, but not kind of what you'd expect. You'd think that kind of convergence would cause correlation to go from zero to 20, 30 back towards historical norms. That's not what we've seen. So, I kind of see it as a little bit of coiled spring in index volatility. Index volatility just has a lot of potential energy in it, if we ever were to get an event, because you're probably going to get pick up and movement from an event. You're going to get volatility expansion because, hey, we're moving now and you're probably going to get correlation to pick up as when something meaningful happens in the market, hey, everything starts moving in lockstep again. So, index volatility seems sneaky mispriced.