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0:00
Clay Finck (01:27): Welcome to The Money Investing Podcast. I'm your host, Clay Finck. And today I'm joined by Kevin Davitt from Nasdaq. Kevin, welcome to the show. Kevin Davitt (01:36): Thank you so much for having me on, Clay. I'm really pumped about this conversation. I'm looking forward to it. Clay Finck (01:42): I am as well. To get us kicked off, let's talk a little bit about your background. Tell us about what you do at Nasdaq and what you've been working on in 2022.
0:28
Kevin Davitt (01:53): So I am part of Nasdaq's index options team. From a title standpoint, I'm head of content, which means I create written and visual content with an emphasis on Nasdaq index products. I've worked in and around the derivative products for my entire career. I started in the derivatives business after college as a clerk for a big proprietary trading firm based in Chicago. And then after a year of training, I started trading for my own account and managing options risk.
1:04
Now, through the years, I've traded equity, ETF, index options, both on trading floors and off. I've also traded commodity futures and options. But when I think back, I think about my first couple of months on the trading floor where I saw, so it's late 99, early 2000, I saw the Nasdaq composite double, and over the next two years, I saw the same index lose about three quarters of its value. Kevin Davitt (02:52): So I've been around for a number of market cycles.
1:37
They started back when I had hair and not a super gray beard. But I joined Nasdaq earlier this year after working for another exchange, and my focus is on our index option suite of products. The flagship product is the NDX option suite. So those are options on the Nasdaq-100 index, and there are also smaller notional index products like X and D that tracks the Nasdaq-100 as well, but it's a smaller product. I can explain that if need be.
2:12
And then beyond that, we have a VOLQ index, which is a dynamic measure of one month forward volatility expectations based on Nasdaq-100 options. That can be a very useful indicator, we'll probably talk about that too. There are tradable VOLQ futures. And as of last month, VOLQ options. So that's what I'm focused on here and now. And I look forward to talking to you about those products, the evolution, and wherever this conversation takes us.
2:42
Clay Finck (03:58): I'm really looking forward to what we're going to be diving into today. We're going to be chatting about derivatives and volatility, which are two items you definitely know quite a bit about. Let's start with derivatives. This is a market that's just grown and grown over the past couple decades. For those listeners that might not be super familiar with derivatives or options, I'm pretty sure those terms are essentially interchangeable.
2:59
Talk to us a little bit about what they are and why they even exist. Kevin Davitt (04:28): All right. So the point you just made is a perfect one, in that, derivative markets are typically associated with futures and options. Okay? So, that's our foundation. But both futures and options are just tools for risk management and exposure to markets. When you really distill it down, there are agreements between two parties, so they're contracts, whether they're futures or options.
3:37
Now the value of a future's contract or an options contract is tethered to or derived from something else. So to give you an example, there, there is a futurist contract for the Nasdaq-100 index. There are options on the Nasdaq-100 index. There are futures on everything from lean hogs to crude oil, to Euro, dollars. And in the equity options world, there's about 5,000 different optionable equity products these days, so that's grown by LEAPS and bounds.
4:15
But at their core, on an elemental basis that are contracts with rights or obligations, the contracts value relates to another market, so it's derived. And I enjoy perspective or the role that history an awareness of history. Kevin Davitt (05:51): So I like to point out that derivatives have existed since the time of the ancient Greeks and Romans, legitimately. These are not new markets. There's been huge growth, but they're not new markets.
4:48
So Hammurabi's code allowed for somebody to lock in the price of a good today for delivery in the future. And this guy named fails contracted with olive press operators, thousands of years ago for the right, but not the obligation to use their olive presses on or before a specific date. And that's essentially a call option. So when I think about U.S. markets, you have to go back to understanding the evolution, the middle of the 19th century.
5:21
So mid 1800, the Chicago Board of Trade was established. And if you're, whatever, aware of history back then, the economy was dominated by agriculture, canals and railroads were the primary modes of transportation, history buffs, manifest destiny, that's what we're talking about. Kevin Davitt (06:50): But in 1848, these clever Chicagoans launched futures markets on grains like corn and wheat. Now those markets allowed farmers who raise grain to sell their expected crop, which comes
5:57
to market at a predictable point in the year, at a specific price for future delivery. And it allowed those who needed grain to lock in the price that they're going to pay for that today, to service future needs. My point here is that both parties are offsetting a preexisting price risk. Derivatives have been and continue to be, at least in my estimation, primarily tools for risk management. Now use cases have certainly evolved as have the markets generally.
6:32
But in brief derivatives are contracts and there are tools to manage risk or gain exposure to a market of interest. Did that make sense? Clay Finck (07:46): Absolutely does. And when you talk about the farming example, that's when it really starts to click for someone they harvest a crop today, they need to sell it six months from now. And they can use the future's market to essentially lock that in and ensure that they aren't going to have to sell it six months later at a much lower price.
7:07
Kevin Davitt (08:07): That's absolutely spot on. You expect your corn to be ready in a month's time, you can prepare for that six months ago, a year ago. And that's valuable. Clay Finck (08:19): Now the problem with derivatives or maybe options specifically is people trying to chase returns. For example, if someone buys a call option on Tesla, they might see 1000% return if it goes up a certain amount, say the stock goes up 100%.
7:41
So you really lever up your returns in a way, but on the flip side, you risk all of your capital potentially during that same time period. A lot of people almost use options almost like as a tool for gambling. So I'm curious if you have any basic advice for listeners that are new to options and want to learn more about them and maybe start utilizing them in their portfolio. Kevin Davitt (08:57): I do. I think the narrative you bring up has gotten a great deal of attention over the past couple
8:14
of years. We are drawn to returns. We're drawn to risk, generally, or at least I would make that argument, but it goes down a very different path. And I would also argue that people have done that with individual equities for years, but when you talk about derivatives, understanding the point you made there is that these are levered tools. So I can gain exposure to a market that's worth X number of dollars with significantly less than that.
8:51
And when you're leveraged and things go well, that's wonderful. It's the flip side of it that you have to be most concerned about, and our brains aren't necessarily wired to operate that way. So that brings me to something that arguably keeps me in work, is that you need to educate yourself and that's not intended to be patronizing, right. Kevin Davitt (09:56): I had to be a clerk for a little over a year where I was exposed to the options market, day in and day out before I was allowed to
9:21
trade a single contract. Now, do I think that it requires a year's work before you could trade options? No. But in the role I was aiming toward, I was going to be in a position to manage a lot of risks, so the requirements are different. But the point is, if it's of interest, invest in yourself, because that pays off pretty much, no matter what you're talking about, another point. And these are my opinions. Personally, I don't find great utility in paper money accounts.
9:54
So you alluded to what I think is natural human behavior. And I think behavior changes with paper money, and you're forced to learn when it's real. Okay? So I'm a fan of analogies. Kevin Davitt (10:45): I grew up caddying at a nice golf course. And I would see these guys hit balls on the range before a round, right, controlled shots. They have distance. But then when you get up to the first tee and there's three other people and a caddy,
10:29
maybe two caddies and the course in front of you, they swing differently. Now, I understand the importance of working on the range, but I think you really learn from putting capital to work, and beyond that, or when you're in a position to do that, understanding that it needs to be appropriate capital. I think you need to have a plan and stick to your plan. You need to behave more like an algorithm, and I'll hopefully be able to explain what I mean by that.
11:04
You have to know exactly how and why you're making money. And if you're unable to explain how you're making money using options, in my estimation, there's likely trouble around the corner. Because far too many people will look at Twitter and somebody posted their accounts up, 1000% on these Tesla calls, right, two years ago, whatever, even today. Kevin Davitt (11:50): But that person doesn't know where or why they're making money.
11:35
And there's this behavioral tendency to conflate that with some natural aptitude. And those people, they'll move naturally to like, "If I'm making this much money trading one or two lots, why am I not doing 10?" And then something goes wrong. So the way that I try to enforce this type of discipline is to write down an entry point, my reason for assuming any risk, as well as my exit plan before I put any risk on. So I keep a journal.
12:14
And I have a plan for if things go as I forecast and I have a plan for, if things do not go that way, because at some point they will. Kevin Davitt (12:31): So just a quick personal example, last week. So middle of July crude oil sold off hard in the middle of the week. And I am not comfortable trading crude oil futures outright, where I would just buy or sell them, but I am comfortable using defined risk option strategies. So crude traded briefly below 90 bucks a barrel.
12:49
I was comfortable with the idea of long exposure or a position that would benefit if the market remained where it was or moved higher. And so I chose to sell a slightly out of the money, $2 wide, put spread, and collected a buck. It expires this week. I collected $1000 because of that contract multiplier, that leverage that's great when it works well and a nightmare when it doesn't. Kevin Davitt (13:18): But in a worse case scenario, crude oil does
13:18
what it did two years ago, where it went negative because of a unique situation. The most I could lose was $1000 because my spread was two bucks wide. And it's that type of approach, in my experience that takes the behavioral component that we've alluded to a couple of times now out of the equation, because I think people bargain with themselves unless there's a clearly defined outline for difficult situations.
13:49
I think this plays out in markets, I think it plays out in essentially anything that's difficult. I try to set up a running plan because it makes it way more likely that I'll follow through. I'm going to run X miles this week by doing this on Tuesday, Thursday, and Saturday, right. Make a plan, stick to it, and I believe the likelihood of success in any environment goes up significantly when you do that. Clay Finck (14:14): The reason I've mainly avoided options, for
14:26
the most part anyways, is because of just the short term nature of them. I feel like it's almost a guessing game for someone like me. I get that you can use them to hedge your downside, but I'm primarily interested in buying and holding for the long term. And I think I'd like to add on to that and say that I think there is a way to combine an option strategy with a longer term approach. And I think a way to do that is through what people often call leap, and that's just purchasing
14:59
a long term call option. Clay Finck (14:50): And oftentimes the furthest out you can purchase is about two years. Say you see a sharp draw down in a company, you have really high conviction in, call it Apple, or even something like this S&P 500 or Nasdaq. You see a sharp draw down, you're like, "Hey, I think this is a really good risk reward opportunity." You can purchase the LEAPS and instead of achieving call it a 50% return over the two
15:24
years, you might get, I don't know, maybe a 200 or 300% return. So I think that's one way that we can combine this option strategy with a longer term approach. Kevin Davitt (15:22): I think you've clearly done some thinking about this. I think the news around this short dated nature of options is arguably overblown. There has been a tremendous amount of growth in that short dated maturities. But let's talk about or tease out some of the points that you made that from my estimation were spot on.
16:03
You can use options and particularly the longer dated options like LEAPS as a bit of an equity replacement strategy with in many situations, a more favorable risk reward dynamic. But I want to make this salient to your distinction, or let's make an important distinction between an investor like yourself, who's got a long term time horizon and a trader, right. Because that distinction's important, and I'm not judging one or the other, but timeframe matters.
16:41
Like I said, there's been significant demand for short dated options, but these tools will work in similar ways, independent of your time horizon. Kevin Davitt (16:23): So there are options that will expire every Friday. And you alluded to it, but this might be news to you. There are also options on index products that expire in December of 2027. Now many LEAPS don't go out beyond two years, but in index products they do because there's demand for them. That's almost like 2000 days from now.
17:19
There is a huge time continuum or maturity span where these tools can be used. I want to give another analogy or an everyday example, right. Like the grocery store in my mind is somewhat like an exchange. There's 1000s of items, they're all products, right, SKUs, food or food-like things. Now I typically get the same group of items because they serve my needs. And I think about the options landscape somewhat similarly. Kevin Davitt (17:17): So some people are interested in short dated
17:54
options on products like Tesla or Netflix or whatever. Others are inclined to shop for options on the Nasdaq-100 that might expire at the end of the calendar year. So that brings me to what I think will be a helpful hypothetical example and something you've probably heard of, if you haven't done it already, is that long term investors will often imply what's called a collar strategy. Many again, longer term investors will evaluate performance annually. You very well may do that.
18:37
So I'm going to explain a hypothetical based on December 31st of 2021, so just over six months ago. Back then, end of the year, the Nasdaq-100 was measuring around 16,300. So let's also imagine that, that hypothetical person would be comfortable or would love to see the market move up 10% over the next calendar year, and they're concerned about the Nasdaq-100 falling by more than 15% over the course of a year, right, just for sake of example.
19:13
Kevin Davitt (18:27): Now I'm assuming that, that person has a portfolio that behaves, that looks like the Nasdaq-100. So it's likely skewed toward technology as opposed to financials or something, right. That's an important thing that you need to determine. And I'm also assuming that, that portfolio is worth one and a half million or more. I'll explain that. But that person could use one call option, one put option on the NDX and they could establish
19:42
what people call a collar, that expired at the end of 2022. Now I could go into the weeds on the specific strikes, but I don't think that's super helpful. You sell a call that's 10% out of the money, you buy a put that's 15% out of the money, and typically the premium that you collect for the short option offsets the premium paid for the long protection. Kevin Davitt (19:18): Now, in that case, there's no cash outlay.
20:12
But what I'm focusing on is that we used a relatively simple approach where this individual still has full upside exposure up to that limit of 10%, and they've established a protective floor, if the index declined by 15% for that calendar year. In this example, you're capping your upside to finance downside protection, and people find that valuable. So let's fast forward. And in fairness, the market significantly lower, as everybody listening to this likely
21:10
is aware, to a couple of days ago when I just calculated what this hypothetical would be worth right now. Kevin Davitt (20:00): So the hedge, the options element that I just outlined would be worth $215,000 doing the one lot. So the hedge is making money, that hypothetical 1.5 million portfolio is down about 400,000 based on the draw down in the Nasdaq-100, okay. So this hypothetical portfolio is still down, but the net impact is about 185,000 or 12%
21:47
versus roughly 25% on just outright exposure, no downside. So I'm going to pose a question to you now. As a long term investor, how did you feel in March of 2020, to go back to that example, or a month ago, when broad based indices had declined by in the case of the Nasdaq-100, 33% for this calendar year. What's your mindset and to what extent do you think that impacts your decision making process? Clay Finck (20:59): Yeah, of course, for most people, it doesn't feel very good.
22:28
I guess my mindset would be, I'm not selling and I'm potentially maybe buying even more. Kevin Davitt (21:09): That's admirable. It's normal for some people, but I think in a large part, that can be a function of where you're at in life, right, and a whole lot of other factors. I do admire it and for whatever it's worth, I think it's the right approach. But in my experience and looking at a whole lot of data, your mindset is often very different when your primary risk is insulated, right.
23:10
I don't think your decision making process is impaired the same way. There's less panic period, if I'm down 12% than if I'm down 30%. Now a whole bunch of data shows that historically, investors long term investors, tend to be most excited to buy a market when prices are high and much more inclined to sell out when prices are low. Again, I tip my cap to you for that awareness, but you've probably seen one of those roller coaster visuals that shows how investors react.
23:45
Kevin Davitt (22:07): And these are things that are put out by the advisor community. When we have moves, like we've seen this year, capitulation tends to happen very near lows. Now, downside volatility freaks people out, and they often make decisions that in hindsight, and you're clearly aware of this are terrible. Easy to say in hindsight. Now an individual that hypothetical, that had the collar on that, had some downside
24:15
insulation might be much more inclined to add exposure in the market a month ago, or at some point in this year, as opposed to somebody that's just outright exposed. And those kind of behavioral elements are something that I find fascinating from a personal evaluation standpoint, as well as from an exchange and the industry that I'm in standpoint. Clay Finck (22:55): I might be giving myself too much credit.
24:43
I wouldn't say I'm by no means the perfect investor, that doesn't get excited when things you know, are doing well and not taking on more risk when things get hot. And you're alluding to this beautiful thing called volatility, which I'd like to dive more into. And as you mentioned, the markets have been volatile as of late. Maybe you could talk a little bit more about that. Kevin Davitt (23:21): I sure can. But just going back to your last point, what you said was you're human, right?
25:16
And evaluating human behavior is fascinating. And from a personal standpoint, being aware of your tendencies can be really helpful. So you brought up volatility, it's a topic that I really enjoy. And if you don't mind, let's go back to this Socratic method. Can I ask your take on volatility because I think it can be interesting from a framing the conversation standpoint? So when you, Clay think about volatility, how do you define it? Clay Finck (23:58): It's funny.
25:55
It makes me think of people talking about risk. A lot of the academics will say that risk equals volatility, and we fall more into the buffet school thought where risk is permanent loss of capital. So to your question about volatility, I would say volatility is simply just a measurement of how much the price of an asset moves. So we can look at volatility when constructing a portfolio, say someone that's younger like
26:24
myself, I'm more willing to take on more volatility because that could potentially lead to higher returns. Whereas flip that on its head, you have someone that's near retirement, they want to preserve their capital, which means they want to have less volatility in their portfolio and they're willing to give up some of those returns. So yeah, I would just say volatility is how price sensitive a particular asset is. Kevin Davitt (24:51): So from a capital market standpoint, I would
28:44
say you knocked it out of the park. Spot on. I take a bit more of a metaphysical and that behavioral standpoint to it. So I argue, and I'm not saying I'm right, but that volatility just is for the point you made, change is a constant. The rate of change, however is not. But, and I think this and pointed it out well, volatility is why people invest, whether they realize it or not. But the way that we typically experience volatility can be really, really different.
29:28
So it's a word where the definition, which I think you nailed, at least from that capital market standpoint is really different than the connotation of volatility in our everyday lives. And you know that full well too. Kevin Davitt (25:44): So volatility, like you said, is a way to quantify the degree of change in capital markets or in a specific asset. And it's typically expressed as an annualized standard deviation, right. Now that might make some people yawn, it might get you excited.
30:03
Let's put some numbers around it. So the highest realized volatility for a calendar year, going back 15 years for the Nasdaq-100 was unsurprisingly 2008, that measured just over 42%. Now let's give that a little context. Realized volatility calendar year 2020, so our pandemic year for the Nasdaq-100 was over 36% in the ballpark of 2008. But as you likely know, in 2008 for the calendar year, the Nasdaq-100 declined by nearly 42%. But in 2020, the index gained almost 49%.
30:51
Kevin Davitt (26:43): So my lesson here, if there is one is twofold. Volatility measures are non-directional and volatility just is, but it's not how most people think about it. Maybe a lot of the people that listen to your podcast, and again, well done if that's the case, but most investors from my standpoint, associate volatility with downside. And so from that standpoint, passive investors are inherently short volatility all the time.
31:32
So then 2008 is bad volatility, and 2020 is good volatility, but it's just volatility. Clay Finck (27:26): Okay. You just said that passive investors are short volatility. Could you explain what that means for us? Kevin Davitt (27:33): Yeah. That's somewhat abstract, but as you know, markets, let's just speak about broad markets, right, but you can distill it down to individual names as well, markets tend to move lower with a far greater velocity than they move up. Okay.
32:11
So when there are volatile markets, 2020 is more the exception than the rule in that we got both. All right? And so people, long term investors benefit generally from low volatility markets where the market exhibits typically a relatively slow grind higher. I think about a 2017 example, so, what's that, five years ago, the calendar year valve for the Nasdaq-100 was like 10%. So compare that to 2008 or 2020. Kevin Davitt (28:26): Back in 2017, the Nasdaq-100 was up 33% for the year.
32:58
It was a really slow, very consistent grind higher, long term investors love that. It's a low volume market. It tends to be great, but capital markets still exists because volatility exists, and that rate of change is going to ebb and flow. But long term investors generally benefit from low volatility markets. And so when volatility is high, they're seeing that draw down. And so by extension they're implicitly short volatility, almost any asset, right. You own it.
33:35
Much more people own things, then they're short it, and that makes you implicitly short volatility, short, a big change. Does that make sense? Clay Finck (29:12): Yeah, I think so. What you're just alluding to there reminds me of the phrase, "The market takes the stairs up and the elevator down." And I think that makes it, since a lot of people are fairly emotional investing, it makes it even more difficult to be a long term investor because when the market's going
34:05
up, it's like, "So slow, it's so boring." It's the Warren Buffet style of just letting your money slowly compound over time. And then when there's chaos in the markets, you're like checking your account and it's down 10% in a month, you're like, "What the heck's going on? The world's going to end." And that's when people get emotional, is when they see those crazy changes in such a short period of time. Kevin Davitt (29:51): You are spot on.
34:31
The point you made about the stairs up and elevator down is a perfect one on the trading floor. And I think it's potentially a good segue to where we might be headed. But one thing, one measure, a flip side to that volatility measures are the opposite. They take the escalator up and the stairs down. Volatility tends to move higher really quickly, and it normalizes over a substantially longer timeframe. There's an inverse correlation between volatility measures and the reference assets.
35:12
So that's something that we could dive into, if you're inclined. Clay Finck (30:34): I actually wanted to bring up this chart you actually shared on Twitter that I found really interesting. It showed that 45% of stocks are currently down 50% or more. 22% of stocks are down 75%, and 5% of stocks are down 90%. So when looking at these metrics and the drops, they're somewhat similar to what we've saw in the COVID crash, but a lot of these stocks are at much higher elevated levels now.
35:49
And now the downturn is not as swift as the COVID crashed either, but when looking at corrections like what happened in 2000 after the tech bubble and the 2008 great financial crisis, the chart actually shows that there certainly could be more pain to come. I'm curious what your thoughts are on the current downturn in volatility. Kevin Davitt (31:22): It's a great question. And I just want to be perfectly clear.
36:17
I work in a compliant landscape, right, this is my opinion, and I'm going to try to speak broadly about it. But I have a history with these markets. So grain of salt, right. You brought up this broader point about looking underneath the hood. I think one of the biggest changes over the past two decades has been this emphasis on indexing because in that situation, so you have a Nasdaq-100 down 25% this year, but
36:56
if had Facebook or Meadow or Netflix, right, if that was your exposure, it's significantly worse. Okay? Indexing whether there's roughly a hundred constituents or 500 or 5,000 spreads that volatility out. And that can be a very useful thing from a long term standpoint, right. It goes back to that example where somebody's up some big percentage number on a short dated option. Yeah, but how's that play out over the course of the next year or two years or three years.
37:36
Kevin Davitt (32:35): So bringing it back to your question about, in my opinion, what does that say about where we're at right now or what historical corollaries might there be? There are elements of the macro backdrop here and now that I think are reminiscent of both timeframes in unique ways. I think it is also very different. Let me bring up one point, and this is a little bit dated now because of those names that
38:10
are down 75 to 90%, we're largely technology focused firms that we're not making money. And there's a market for that, right. Growth companies have changed the world, but at some point you do have to make money. And that relationship in some ways is tethered to the overall interest rate environment, and that's changing. That was also the case in 2006, 2007, right. Kevin Davitt (33:31): Easy money, loose monetary policy does what it's supposed to do.
38:52
It stimulates, and it works its way through the system. And that transmission mechanism, whether it's the federal reserve or the ECB or the bank of Japan is stimulative. And that is changing, which is somewhat similar to 2007, '08. Now what that means, whether we are likely to have seen the worst of it a month ago in the middle of June. So ironically, or perhaps appropriately the day after the June Fed meeting markets found support and have since rebounded fairly substantially.
39:34
In fairness, there is another Fed meeting a week from now and probably before this comes out, but we're back in that environment where people talk about the next Fed meeting is the most important ever. And if that's the case, you're probably too exposed because it shouldn't be, right. These changes are gradual. Kevin Davitt (34:32): And so I think bigger picture, my appreciation of history, whether it's from a geopolitical social standpoint or a more market focused
40:09
one, is valuable because you can draw comparisons, but just know that it's never the same. And if you can read the tea leaves and I'm not saying I can, that can elicit a more well informed opinion about the future and just go back to one kickoff point, right. It can say, "I'm not allowing this to happen. I'm not allowing 2002 to happen," where over the course of a horribly painful year and a half, the Nasdaq-100 loses 75% of its value. Is that possible? Yes, of course.
40:50
And tools like we're talking about allow people to manage their exposure when they're proactive about it. Clay Finck (35:22): We've been talking about volatility, and I look at the headlines when things get crazy and I always see the VIX mentioned. I know VIX is related to volatility, but I couldn't tell you exactly what it is or why it's important. So could you outline that for us? Kevin Davitt (35:39): It's an index that I'm familiar with.
41:22
We'll talk about similar indices, hopefully what they do tell you and what they don't. I'd like to start by making the distinction between realized volatility, which is backwards looking based on historical prices, right. It is a rote calculation based on your timeframe. And that's what I was talking about with calendar year volatility previously. The VX is an index that is forward looking and that's important. It's a forward looking estimate of volatility based on some input.
42:00
So let's talk through those, let's compare them to others and educate your listeners. So the VIX index has been around since the early '90s, the VIX index today uses two strips of S&P 500 index options that are time weighted to create a 30 day constant forward volatility measure. That was a mouthful, a constant 30 day forward volatility measure. Kevin Davitt (36:43): I'm going to explain this stuff. Now, the VIX uses a wide strip, a wide swath of options on the S&P 500, including well
42:43
out of the money calls and well out of the money puts. For those with a statistical bent, it's a variance replicating approach. Now, what does that tell us? That's what you're really asking. Well, the prices that people are willing to pay for options reflects the amount of volatility that the marketplace is anticipating for the life of that option. That's important. So measures like VIX, the volatility index, or VOLQ, which I'll talk about briefly give
43:24
people a quantifiable way to look at how much volatility the market is pricing over the next month because the inputs are one month options. Now, those measures are expressed as an annualized standard deviation like you're used to from historical looking volatility measures. So let's give this some numbers. Kevin Davitt (37:47): So when the VIX index is 24, roughly and VOLQ is 29, ballpark where we're at today or yesterday, that forecast is very different when compared
44:05
to when both measures were around 80 in March of 2020, or even last summer when they were at 16 and 20 respectively. So I think about one of the apps I use on my phone often, it's the what's the weather going to be like? Because it matters. And it's imperfect, but it's an indicator that I find useful based on a whole bunch of data points. And that's essentially, I mean, from an analogy standpoint, you take data, you take these inputs and you distill it into something of use.
44:45
Now, why does it matter? Let's go back to volatility in a general sense again, and let's think about our everyday lives. You have a general sense of how much volatility has existed in your life in the past, right? You can't quantify it, but chances are, you remember some really key, what we'll call pivot points, just like important points in your life. Kevin Davitt (39:02): Now let's imagine for the sake of example,
45:23
that there is some indicator that had access to Clay's calendar of events, all the things you have going on over the next month, and then that could spit out some estimate of potential future volatility for you to consider. I know it's a little bit of a stretch, but my question is that intriguing, right, like a tool that gives you some indication of what the future might look like based on known inputs. You could compare that to values previous and possibly change your behavior in the future.
46:01
I'm dating myself here, but I think about Martin Landau character in Entourage, where he'd be like, "Is that something you'd be interested in?" So that's my question to you, Clay. Theoretically, is that something you'd be interested in and why? Clay Finck (39:54): What I'd be interested in that I would say yes, because people are kind emotional creatures. They want to know if something wacky is about to happen to them, whether it be good or bad. Kevin Davitt (40:05): Correct.
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Having some sense of what the future might look like, what's anticipated, understanding it can change is valuable. That's my big picture takeaway. And while it's hopefully clearly an analogy, that is in so many ways what forward volatility measures like VOLQ and VIX do. The inputs there are index options. So in the case of VOLQ, that index uses Nasdaq-100 index options and it spits out an estimate for one month forward volatility based on how those options are priced, second after second.
47:20
And keep in mind that options markets incorporate known unknowns. So things like earnings, which are absolutely on the calendar here and now, or a Fed meeting or a monthly jobs report, those are factored in and distilled. These estimates reflect that known unknown. So the VIX index, VOLQ, they are quantified expressions of that sentiment. Many people consider it exceptionally valuable. Kevin Davitt (41:15): And there's one other really important point to make about forward volatility.
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Now, capital markets, options in particular are always forward looking, but they also reflect the past to a certain degree. So markets and volatility measures, which I mentioned a couple minutes ago, have an inverse relationship. And that, from an actionable standpoint is one of the key reasons that a measure like VOLQ or VIX has great potential utility. So just to use an extreme example, back on February 19th, 2020, hopefully most people
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can remember that, U.S. equity markets closed at record highs, all right. On that date, the VOLQ index was below 16. The forecast is clear, right, despite it being late February. But then I don't have to rehash what happened, right. Things changed and unknown, unknown occurred and the economy and the markets went wild. And so a month later, Nasdaq-100 is down 28% similar to the drawdown we've seen this year. And where was VOLQ then? Nearly 80. Okay?
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Kevin Davitt (42:26): Now, this is also important. Just to be clear, I've referenced a VOLQ index or a VIX index. Neither of them, neither index is tradable. So you cannot buy or sell VIX, you cannot buy or sell VOLQ. But there are futures markets that are listed that you could choose to buy or sell, and there's also options where the futures markets are the underlier. And it's those products that from a derivatives landscape, we talk about ecosystems that complete
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this index ecosystem, because if I can buy something that I expect would go up when the index that is my primary risk moves lower, that helps portfolio performance. So for the quantitative types, there's a really long demonstrable history of negative correlation between forward volatility measures and your reference asset, whether that's the S&P 500, the Nasdaq-100 or Apple stock. Kevin Davitt (43:29): My last point is that these forward volatility
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measures have a long history of inverse correlation to the reference assets. So when you said the markets take the stairs up and the elevator down, volatility measures are the opposite. They take the elevator up and the stairs down. And that teeter-totter relationship is what's valuable because there are products that you can buy that are tied to derived from those indexes. And that can be valuable during those periods where you have tremendous uncertainty and
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you have markets, broad markets down significantly. Clay Finck (44:10): So very helpful, Kevin. I'd like to tie options into this. How does the options market tie into all this volatility, VIX VOLQ? Kevin Davitt (44:22): It's a really good question. They're inextricably connected, but let's understand the how and why, because that's where learning happens. So I'm going to focus for just a couple minutes on index options because they are my focus, but they're also simpler.
50:52
And there are a couple of unique benefits associated with them that I'll explain, so I'm putting on my educator hat right now. There are five inputs to the value of any index option, and we know nearly all of them. So your question is how does volatility relate, play out in the options market? Five inputs to the value of any index option, we know almost all of them. So the underlying price or value for the index, that's known for hedging purposes, the futures
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markets are the key there, but we know where that index is measuring. The second one is your strike price. Kevin Davitt (45:16): In other words, where you have the right to buy or sell the underlying, the third one is duration or maturity. How long until that right or obligation expires. So you think about more commonplace transaction. You don't buy insurance and perpetuity. There's a term, it's typically annual.
51:56
So it's very similar in the options markets, but that maturity could be a day, it could be a year, it could be, as I outline 2027. Eventually all options expire. The fourth thing is the risk free interest rate. Big picture. I assume your audience knows that the time value of money plays a role throughout capital markets. It matters. You're seeing it play out this year, certainly changes in that rate. And then the last one, there is a volatility assumption that is baked into the price of
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all options. Now we're able to back out what volatility is being implied by an options value, using an options pricing formula, right, like Excel is amazing. Kevin Davitt (46:18): So let's look again at those five really quickly. We know the underlying price. We know the strike, we know exactly when an option expires, we know interest rates. They can change, but typically at a known cadence. We make an important assumption about future volatility for that underlying.
53:06
And forward volatility is that dynamic, unknown variable that's baked into every options price. So if you buy or sell any option, it's baked into the price. Now let's go back to some behavior that we referenced earlier and think in economic terms. Your willingness to pay more or less for something is described as elasticity, price elasticity. Kevin Davitt (47:02): So let's imagine for just a second, because
53:36
this is how people behave, that your house is uninsured and you have a kitchen fire that's spreading. So in that scenario, you are willing to pay a whole lot more to get insurance than you were the day previously. That's just how it works. And that's how people behave when markets drop with significant velocity. They realize they're uninsured, they have significant exposure and they rush to buy coverage typically in the form of index put options. So what happens then?
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We'll both realized and forward volatility estimates tend to go up really quickly, and the price of index options increase across the board. Kevin Davitt (47:47): Now we're on the topic of index options and I wouldn't be any good at what I do if I didn't mention two other key differences, because they might be new to many listeners. Index options, again, they're arguably simpler in many ways. They are European styled, almost all of them.
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All that means is they can't be exercised or assigned until that expiration date. Now, by comparison, any equity, so an Apple or a Tesla or a Netflix option, they're all American styled, they can be exercised early. That's a risk for options sellers. It's one of the reasons that many, what we call market participants gravitate toward index options. Kevin Davitt (48:25): Now beyond that, index options settle to cash if they're held until expiration.
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And that's another thing that many market participants prefer. By contrast, any in the money equity or ETF options will expire into physical shares of the underlying. So that can be a good thing, but you need to have the funds in your account to be long or short, the associated shares. And there are a lot of people that are just looking for options exposure. They skew toward the trading types, as opposed to the long term investors.
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Now, a couple other brief things with respect to index options, there's huge choice with respect to expiries. So how far out in time you can look. I reference that with the December, 2027 example earlier. There are also index options that expire multiple times a week. Kevin Davitt (49:17): Now, last thing I'm going to talk about, but maybe I should have led with it, is that index options typically get preferential tax treatment when compared to equity or ETF options.
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Now, this is genuinely something that long term investors think about and plan for. I'm going to be clear. I'm not a tax professional, but I know a bit of market history, I know a bit about section 1256 of the IRS code, but I'm not going to go into that because everybody would be tuned out. But the key takeaway is that index options are typically taxed at 40% short term rate, 60% long term. And equity options, it's the opposite. 60% short term, 40% long term if held for less than a year.
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Now that can add up over time. If you happen to be interested in more about 1256 contracts and you like history, you should read about Dan Rostenkowski, that is a classic Chicago name. Kevin Davitt (50:14): To me, it sounds like a character that would've been on the Chris Farley Saturday night live skits, but Rostenkowski was head of the ways and means committee in Congress during the Reagan years when options were really niche
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business, and his district incorporated the Chicago trading exchanges like the CME. And he worked to include that beneficial 1256 provision into a much bigger tax reform bill. And if you fast forward like 40 years or more to modern day, you have traders in Chicago all over the place that legit have pictures of Dan Rostenkowski in their basement because they're so grateful for the tax implications. That is a real statement, "I know people." Clay Finck (50:57): Interesting.
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Before we close it out, I'd like to ask you, what are some of the things your team at Nasdaq is working on in relation to the index options and what else you have going on for the rest of 2022. Kevin Davitt (51:10): Well, thank you for asking. I like the way this guy, John Black, that I worked for expresses how our team worked. The index options team, he says operates like a startup within a much larger technology driven company, Nasdaq, the parent.
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So index options, like I've described our growth area, for the reasons that I've highlighted and Nasdaq parent company invests in it as such. So what are we up to? A month ago, we launched VOLQ options. Those are cash settled options based on VOLQ futures. We just had our first expiration yesterday. That's exciting. So our group and myself will continue to call attention to the importance of forward volatility
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by doing stuff like this, ways that you could potentially incorporate VOLQ futures or VOLQ options to either offset some volatility risk, or to gain exposure to directional moves in volatility. If your listeners have any questions about Nasdaq products, anything I mentioned today, I genuinely hope that they reach out because this is part of a much longer term growth plan. Kevin Davitt (52:20): I think that volatility products help to irrigate
1:00:24
the overall options landscape for the Nasdaq-100 for the smaller related products like X&D. And we're always working to highlight use cases for index options. Now, younger people, I think this is fairly obvious, but in some circles I need to make the argument that the Nasdaq-100 reflects the economy of the 21st century. So gone are the days when we talk about general motors and its relationship to the larger economy right. Now, it's Tesla.
1:01:03
We're not talking about GE, about general electric, we're talking about Apple and Microsoft. And those companies, they have come to the forefront of the global economy, they've dominated it for years now. And they're what drives the Nasdaq-100. It's also what happens to make up many portfolios these days. So I argue that it might make sense to use an index option that tracks the Nasdaq-100, particularly because there are performance differences between, let's say, the Nasdaq-100
1:01:37
and the S&P 500 over both long and short term time horizons and Nasdaq-100. Kevin Davitt (53:34): I get excited about the fact that the Nasdaq-100 has outperformed the S&P 500 for 12 out of the last 15 years. That is something that matters to long-term investors. We also work with brokerage firms that connect to the exchange to educate their clients about the benefits and potential risks associated with options. We have outreached to the advisor community.
1:02:13
I have a colleague that works with the institutional world to grow access understanding for groups like Pension Boards, Endowments, huge pools of assets that are looking to manage their exposure. So we got a lot going on. I am genuinely grateful for the opportunity to highlight some of those things, and I look forward to the work. Clay Finck (54:21): I'm glad you mentioned the Nasdaq-100. I talk with a lot of different types of investors.
1:02:44
You have the value guys saying a version to the means coming. And then I actually had an episode release just recently with Adam Ziesel, who wrote a book all about just value investing in what he calls in the digital age. And it's just so fascinating looking at some of these large tech companies that they only seem to keep growing like weeds. And I think there's a reason for that. And that's why I personally have the Nasdaq-100 as a part of my investment strategy as well.
1:03:16
So Kevin, I've really enjoyed this conversation. Thank you. Thank you so much for coming onto the show and joining me. Before we close it out, I wanted to give you a chance to give the handoff to maybe anything else you'd like to share. Kevin Davitt (55:07): Well, thank you genuinely. I have been a fan of the podcast. I got to listen to the growth versus value one, because there are compelling arguments, right.
1:03:44
But to your question, I would ask if these are topics of interest that there's tremendous resources available, right. You go to Nasdaq, you can look up the specifics of index options, there are tools for back testers, which I think can be really, really. Helpful historical data, that stuff is useful. We also put out options education, options content, if that's of interest. Again, I'm not looking to clutter up your inbox, but every month I'll put out something
1:04:20
that hopefully shines a light on volatility in a unique way that many people appreciate. Kevin Davitt (55:57): We're always doing events like this. We're always grateful for them. And if there's interest, I'm not, you reference Twitter. For me, I'm not super active on Twitter, but I do put some stuff on there, if you care to follow. LinkedIn is probably better. And it goes back to one of those first points I made about the potential benefits of networking.
1:04:53
So thank you so sincerely, Clay, this has been a lot of fun.
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