Quantitative

Strategies FEAR & GREED

IN
VOLATILITY MARKETS
~

Emanuel Derman

Quantitative Strategies Group

Goldman Sachs & Co.

Page 1 of 24

Fear&Greed.fm
 Are There Patterns to Volatility Changes?
❏ Since 1987, global index options markets are persistently skewed.
Quantitative
How do/should volatilities and the skew change as markets move?
Strategies ❏ Every description of data involves an articulated or unarticulated
model. There are at least three “models” for volatility change:
❍ An apocryphal Sticky-Strike Rule, that reflects Greed;
❍ An apocryphal Sticky-Delta Rule, that reflects Moderation;
❍ A theoretical Implied Tree Model, that reflects Fear.
❏ Each rule leads to different predictions for valuing & hedging
options. Which works best? And why?
_______________________________
❏ Traders’ daily reports are sometimes unreliable. They focus on
liquid at-the-money volatility, a moving target, but they own
definite strikes.
❏ Therefore, ignore everyone and look at the data through the prism
of models.
________________
❏ There appear to be several distinct periods (“regimes”) in which
different rules seem to hold.
❏ Often, S&P 500 implied volatilities seems to oscillate between the
Fear Rule and the Greed Rule.....
Page 2 of 24 ❏ Producing Moderation in the long run, but not the short.
 Contents
1. INTRODUCTION: GLOBAL IMPLIED VOLATILITIES
Quantitative
Strategies

2. GREED (STICKY STRIKE)

3. MODERATION (STICKY DELTA)

4. FEAR (STICKY IMPLIED TREE)

5. WHAT REALLY HAPPENS: MODEL REGIMES

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 PART I
Quantitative
Strategies

INTRODUCTION:
PART I
GLOBAL INDEX
INTRODUCTION:
GLOBAL INDEX IMPLIED VOLATILITIES
IMPLIED
VOLATILITIES

Page 4 of 24
 A Persistent Negative Global Skew
A persistent large skew, almost linear, and inconsistent with Black-
Scholes.
Quantitative
Strategies

Global Three-Month Volatility Skews

Mar 99

PART I 50 Nikkei 225

45 S&P 500
INTRODUCTION:
GLOBAL INDEX g
Hang Sendg
40
IMPLIED FTSE 100
35
VOLATILITIES DAX
30
CAC 40
25 MIB 30
20 SMI
25D Put Atm 25D Call AEX

Σ ( K ) = Σ atm – b ( K – S 0 )
Page 5 of 24
 A Negative Correlation with the Index
The S&P 500 index and its at-the-money three-month implied
volatility, Sep 1 1997 through Nov 2 1998.
Quantitative
Strategies

Three-Month Implied Volatilities of SPX Options

PART I 65 1200
60 1150
55 1100
INTRODUCTION: 50 1050
GLOBAL INDEX 45
1000
950
IMPLIED 40
900
VOLATILITIES 35
850 INDEX
30
800 ATM
25 750
20 700
15 650
09-01-97

10-01-97

11-03-97
12-01-97

01-02-98

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Note - you don’t own at-the-money volatility, you own a fixed strike.
 Volatility Behavior By Strike Is Complex

Quantitative
Strategies
Three Month Implied Volatilities of SPX Options

65 1200 INDEX
60 1150
ATM
55 1100
1050 750"
PART
50 I
1000 800"
45
950
INTRODUCTION
40 : 900
850"
GLOBAL
35 INDEX 850 900"
IMPLIED
30 800 950"
VOLATILITIES
25 750
1000"
20 700
15 650 1050"
1100"
09-01-97

10-01-97

11-03-97

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1150"
1200"

What’s going on here?

Page 7 of 24
 What’s The Future Skew?
We know the current skew Σ(K) = Σatm – b(K - S0).
Quantitative
Strategies
Hypothetical Implied Volatility of Three-Month SPX Options

Index 103 102 101 100 99 98 97

Strike

PART I 103 17
102 ? 18 ?
INTRODUCTION:
GLOBAL INDEX 101 19
IMPLIED
VOLATILITIES 100 ? 20 ?
99 21
98 ? 22 ?
97 23

❏ What will happen when the index moves?

❏ What’s the S-dependence in Σ(S,K)?
Page 8 of 24
❏ Distinguish carefully between Σ(S,K) and Σatm(S) = Σ(S,S).
 PART II
Quantitative
Strategies

PART II

GREED
(STICKY STRIKE) GREED
(STICKY STRIKE)

Page 9 of 24
 Complacency or Greed: Sticky Strike “Model”
The simplest & most convenient model for changing the implied
volatility of an option as the index moves is not to change it at all.
This is the or complacency model, or “sticky strike,” the closest thing
Quantitative to Black-Scholes. It’s also the lazy-trader model.
Strategies

“STICKY STRIKE” Σ ( S, K ) ≡ Σ ( K ) = Σ atm – b ( K – S 0 )

Characteristics
❏ Fixed-strike volatility is independent of S.
PART II ❏ Therefore, because of the negative skew, at-the-money volatility
falls with rising S.
GREED ❏ ∆ = ∆BS.
(STICKY STRIKE)
____________

In a rising market, you can think of this model as representing

Irrational Exuberance or Greed:
At-the-money options are the most liquid.
When the market rises, at-the-money volatility falls, and you
are selling the most liquid options more and more cheaply, as
though you need never worry about future index declines.

Page 10 of 24
 How Options Trees Evolve
In The Sticky Strike Model

Quantitative
Strategies Index 90 100 110
Strike Known
90

PART II 90

GREED 100
(STICKY STRIKE) 100

110 110

❏ Fixed-strike volatility is independent of S.

❏ Therefore, because of the negative skew, at-the-money volatility
falls with rising S.
❏ ∆ = ∆BS.
Page 11 of 24
 PART III

Quantitative
Strategies

PART III

MODERATION MODERATION
(STICKY DELTA)
(STICKY DELTA)

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 Rational Moderation
At-the-money volatility is the rational estimate for the future cost of
replicating liquid options issued now. On average, over the long run,
at-the-money volatility should be independent of index level.
Quantitative
Strategies If you have no special expectations about the future, you should keep
at-the-money volatility unchanged.
Given the negative skew, as the index rises, you need to raise every
strike’s volatility to keep at-the-money volatility unchanged.
Traders refer to this as the Sticky Moneyness or Sticky Delta Model.
PART III

“STICKY DELTA”: Σ = Σ ( K ⁄ S ) = Σ
atm – b ( K – S )
MODERATION
(STICKY DELTA)

Characteristics
❏ Atm vol is independent of S.
❏ Fixed-strike vol increases with S.
❏ ∆ > ∆BS.
____________

Page 13 of 24
 How Options Trees Evolve
In The Sticky Delta Model
.
Quantitative
Strategies

Index 90 100 110

Strike Known
90
PART III

MODERATION 90
(STICKY DELTA)
100
100

110 110

❏ Atm vol is independent of S.

❏ Fixed-strike vol increases with S.
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❏ ∆ > ∆BS.
 PART IV

Quantitative
Strategies

PART IV

FEAR FEAR
(STICKY IMPLIED
TREE) (STICKY IMPLIED TREE)

Page 15 of 24
 Why The Skew? Fear of Index Declines!
The skew represent the premium for the fear of a downward market
move and an increase in realized and implied volatility.
Quantitative Relation between the current skew and the expected future volatility.
Strategies
Strike Implied Volatility (%)
100 20%
99 21%
98 22%
PART IV
97 23%
FEAR
(STICKY IMPLIED You can deduce the local volatility at different market levels by
TREE) treating the implied volatility as an average over local (future at-the-
money) volatilities.
Index Level Local volatility (%)
100 20%
99 22%
98 24%
97 26%

These local volatilities are the future at-the-money volatilities feared

Page 16 of 24
to occur in a decline. Note that local volatilities increase twice as fast
with index changes as implieds increase with strike.
 Sticky Implied Tree Extracts Local Volatilities
There is one market-consistent tree - the implied tree - whose
expectations of future volatilities match all current options prices and
the skew. In this view, the skew is attributable to an expectation of
Quantitative higher volatility as the market moves (jumps?) down.
Strategies
You can use this tree to price all options consistently off future
implied local volatilities. This is similar to pricing all off-the-run
bonds off current forwards.

PART IV stock
price
variable local
FEAR volatility σ(S,t)
(STICKY IMPLIED in the future
TREE)

time
several different constant volatility
trees are equivalent to one implied tree

When the index moves, to find the new skew, you roll along the local
vols. This is similar to rolling along the forward curve to get future
yields as time passes.
STICKY IMPLIED TREE: Σ ( K , S ) = Σ atm – b ( K + S )
Page 17 of 24
 How Options Trees Evolve
In The Sticky Implied Tree Model
Index 90 100 110
Quantitative
Strategies
Strike 1 Current Tree

90 110 110
100
90 90
PART IV
100 110 110
FEAR 100
(STICKY IMPLIED 90 90
TREE)

110 110 110

100
90 90

❏ Fixed-strike volatility decreases as K or S increases.

❏ Atm vol falls twice as rapidly as skew.
Page 18 of 24 ❏ ∆ < ∆BS.
 PART V
Quantitative
Strategies

PART V
MODEL SUMMARY
MODEL SUMMARY

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 The Properties of the Models

Quantitative
Strategies

Behavior of
Stickiness Equation for Σ ( S, K ) Fixed-strike At-the-money Delta
Model Option Volatility Option Volatility
PART V
Strike Σ atm ( t ) – b ( t ) ( K – S 0 ) independent of decreases as = ∆BS
MODEL SUMMARY index level index level increases
Σ atm ( t ) – b ( t ) ( K – S )
Delta increases as independent of index > ∆BS
index level increases level
Implied tree Σ
atm ( t ) – b ( t ) ( K + S ) decreases as decreases twice as < ∆BS
index level increases rapidly as index level
increases

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 PART VI
Quantitative
Strategies

PART VI
WHAT REALLY HAPPENS:
WHAT REALLY
HAPPENS: MODEL MODEL REGIMES
REGIMES

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 Which Model Reigns in Which Regime?

Quantitative
Strategies

Three-Month S&P 500 Implied Volatilities

Fear Greed Correction Greed Fear Greed Correction
70
sticky CORRECTION index trends; index trends; CORRECTION
jumpy index: index trends; stable sticky implied tree
strike sticky should be vols rise to should be should be vols rise to
1400
PART VI 65 or
sticky
implied tree sticky delta,
seems to be
sticky delta
level
sticky delta,
seems to be
sticky delta, sitcky delta level
seems to be
jumpy index:
implied sticky strike
sticky strike sticky strike 1300
60 sticky implied tree
tree
WHAT REALLY 1200
55
HAPPENS: MODEL ATM

REGIMES
50 1100 800
850

S&P 500 Level

900
Volatility

45
1000 950
1000
40 ? 1050
900 1100
1150
35 1200
800 1250
1300
30
1350

700 INDEX
25

20 600

15 500
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 Conclusions
Sticky strike (complacency)
Sticky delta (moderation)
Quantitative
Strategies Sticky implied tree (fear)

are intuitively useful ways of thinking about variations in implied

volatility that sometimes correspond to modes of market behavior.
❏ When times are good, and the index keeps rising, the options
market keeps every strike’s volatility roughly fixed, and so the
PART VI pendulum of at-the-money volatility drops.
WHAT REALLY
❏ When times get bad, and the index jumps down a few percentage
HAPPENS: MODEL
points, the market has to compensate for having let at-the-money
REGIMES
volatility drop too far. The pendulum reverses, and moves at-the-
money volatility up at twice the rate as the index collapses.

❏ On average, over the long haul, the pendulum oscillations between

sticky-strike Greed and sticky-implied-tree Fear average out to
sticky-delta Moderation.
Will these conjectured regimes extend through time and across
markets?
Is there a model of stochastic volatility that encompasses this?
Page 23 of 24
 Recent Update: July-August ‘99

Quantitative
Strategies

PART VI

WHAT REALLY
HAPPENS: MODEL
REGIMES

Page 24 of 24
 52.37 43.52 40.86 38.47 35.84 33.59 30.88 28.36 26.14 23.97 22.09 20.29 19.85 22.08 22.13
52.3 42.44 40.15 37.88 Three-Month
35.61 S&P 33.26 30.83
500 Implied 28.32
Volatilities 26.11 24.09 22.25 20.7 19.14 22.78 22.79
45.55 40.44 38.52 36.61 34.73 32.68 30.41 28.1 25.93 24.01 22.46 21.13 20 25.08 24.99
46.01 40.48 38.45 36.44 34.39 32.24 30 27.63 25.51 23.55 21.7 20.27 19.32 24.25 24.37
45 1450
900 950 1000 1050 1100 1150 1200 1250 1300 1350 1400 1450 1500 1550 1600
Rising Index, Atm vol falls to 19% Falling index, Atm vol rises to 25% Rising index, Atm vol falls
skew is about 4 vol pts
50.83 42.54 39.99 37.48 34.88 32.64 30.53 28.14 25.88 23.84 22.17 20.45 19.5 again 19.26 19.13
per 100 S&P pts points
40 49.57 41 38.74 36.59 34.23 32.12 30.05 27.84 25.74 23.79 22.05 20.56 19.23 22.36 22.49 1400
46.67 40.31 38.29 36.13 33.99 31.96 30.04 27.78 25.54 23.65 21.82 20.45 19.64 25.03 24.7
52.57 41.4 39.11 36.69 34.56 32.43 30.05 27.79 25.72
S&P declines 23.69
140 pts 21.58 20.04 18.84
S&P rises 21.27
80 pts 21.81
100 pt rise in S&P
48.21 40.6 38.37 36.11 33.5 31.62 29.7 27.42 25.18 23.33 21.51 20.05 18.86 23.22 22.57
35 49.78 40.16 38.01 35.83 33.44 31.34 29.27 27.19 25.01 23.06 21.42 19.65 18.3 22.68 23.16 1350
50.38 40.21 37.98 35.75 33.43 31.41 29.28 27.02 24.95 23.07 21.49 19.78 18.22 22.59 23.16
45.48 39.06 37.18 35.25 33.37 31.33 29.49 27.42 25.21 23.36 21.83 20.2 18.91 23.07 23.59
Volatility

45.37 39.26 37.34 35.42 33.33 31.36 29.44 27.22 25.15 23.3 21.85 20.4 19.11 24.73 25.43

Index
30 1300
52.22 41.23 39.02 36.7 34.31 32.1 29.62 27.49 25.41 23.43 21.7 20.21 18.95 22.65 22.45
51.29 41.06 38.65 35.84 34.02 31.8 29.61 27.48 25.4
vols by strike 23.45
rise about 3 pts 21.9 20.03 18.89
vols by strike22.91
remain 23.81
42.2 36.56 36.43 34.64 33.26remain31.15
vols by strike 28.23 26.08 24.19 22.29 20.92 19.1 18.17 unchanged
roughly 21.41 again 21.82
25 51.9 37.84 36.06 34.07
unchanged 31.93 29.8 27.68 25.63 23.93 22.03 20.19 18.59 16.94 20 21.1 1250
42.4 39.5 37.28 35.11 32.76 30.51 28.39 26.34 24.21 22.14 20.26 18.73 17.35 17.23 16.8
42.45 37.72 36.2 34.24 32.31 30.28 28.07 25.98 23.98 22.06 20.33 18.9 17.97 16.94 17.31
41.98 39.85 37.05 34.33 32.3 30.04 27.84 25.66 Atm 23.28 21.3as
vol rises twice 19.56 17.94 16.86 16.92 16.63
20 41.89 39.63 36.79 34 32.04 29.8 27.5 25.29 much,23.2 21.22 19.39 17.77 16.54 16.79 16.38 1200
about 6 pts ATM vol again drops
42.4 37.32 35.54 ATM vol 33.6drops about
32.1 3 pts29.99 27.76 25.68 23.52 21.66 19.79 18.33 17.36 15.98 17.96
about 3 pts as index
40.45 38.27 36.08 as index
33.73rises 31.48 29.3 27.05 24.9 22.81 20.9 18.95 17.45 16 17.29 20.87
rises
38.84 38.34 36.38 34.28 31.79 29.72 27.6 25.57 23.44 21.59 19.79 18.11 16.86 17.65 18.22
15 1150
42.22 39.46 34.32 33.35 31.55 29.62 27.85 25.86 23.7 21.94 20.01 18.43 17.57 17.13 18.03
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42.28 39.8 37.34 33.24 31.4 29.67 27.57 25.54 23.5 21.58 19.95 18.43 17.23 16.9 16.91
42.72 39.7 35.29 33.7 31.61 29.61 27.51 25.43 23.39 21.42 19.65 18.07 16.5 15.85 16.32
42.88 39.71 36.88 32.32 30.76 Date
28.88 26.56 24.54 22.69 20.79 18.93 17.38 16.06 14.88 16.1
46ATM 42.47
1100 39.05
1150 36.11
1200 33.52
1250 30.82 135028.39 1400 25.941450 23.71
1300 1500 21.52
INDEX 19.33 17.58 15.76 14.93 15.54
44.2 41.61 35.3 33.35 30.76 29.32 27.26 25.19 22.88 21.29 19.17 17.56 16.1 14.37 15.91