Dori Levanoni
May 9, 2022
  • Based on the SPX options market, April started with a fairly typical distribution, with both the shape and level of volatility close to normal.
  • The distribution was still a little bit more skewed to the left than typical. This type of skew means that investors thought a selloff was more likely than normal, that investors were more sensitive to tail risk than normal, or both.
  • By April 21st, with disappointing earnings news and the increased prospect of a 50bp rate increase by the FOMC, equities began to decline more sharply and volatility rose significantly. The skew, on the other hand, stayed about the same, suggesting that investors’ concerns about a sharp selloff didn’t increase as much as overall concerns.
  • By month-end (Figure 01), volatility rose further, ending well above typical levels. With both volatility and skew higher than usual, it appears that investors are pricing in continued economic concerns.

The curves in Video 01 and Figure 01 are known as the “risk-neutral distributions” of option market participants, derived from all of the options priced right now.


Video 01

Sources: Datastream, First Quadrant, LLC


Figure 01 - Implied Volatilities of Options

Sources: Datastream, First Quadrant, LLC

These curves may look like expected probability distributions, which reflect the likelihood (y-axis) of each possible outcome (x-axis). Expected probability does plays a role in these curves, but they’re actually a bit more nuanced, because in these curves expected probability is scaled by the market’s preference for each outcome. Preference is a bit like risk aversion, and may change with environment or circumstance. For example, market participants could become more sensitive to tail risk when they are worried about funding status.

Hence, if a curve changes, it may be that options market participants have changed (1) their expectations as to how the market will move, (2) their preferences for those outcomes, or (3) both their expectations and preferences.

A typical curve for the SPX options market looks relatively “normal” (i.e., bell-curved), but is a little bit asymmetric, with the left side slightly higher than the right side.

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