Inside Index Volatility – Why Its Underlying Drivers Matter

Volatility risk premium strategies are a common component of liquid alternatives portfolios, offering a scalable source of return with a distinct risk and return profile relative to traditional equity exposures.

Selling index volatility means taking exposure to both single stock volatility and correlation. Understanding these underlying drivers is important when assessing the risk-return-profile of a particular volatility strategy. In this edition of Volatility Spotlight, we examine how these two components drive implied index volatility across different market regimes and what this means for nvestors allocating to volatility strategies.
 

Two forces drive implied index volatility

Index volatility is primarily shaped by two factors:

• the volatility of the underlying single stocks and
• the correlation between those stocks

Single stock volatility determines the extent to which individual index constituents move. Correlation determines how much of those movements remains visible at the index level after diversification. A volatility strategy that sells index volatility directly is exposed to both components!

For investors, analyzing index volatility alone is consequently not sufficient. Understanding its underlying drivers is essential to assess both the source of risk and the quality of the premium being harvested.
 

Single stock volatility dominates in stress

Our analysis of daily S&P 500 Index volatility data shows that the dynamic of these two drivers changes materially across regimes.

In normal markets, both single stock volatility and correlation contribute almost equally to changes in index volatility. As market moves become larger, single stock volatility increasingly dominates.

In the most extreme 1% of observations of index volatility changes, around 70% of the change can be attributed to single stock volatility, as shown in Chart 1.

This means that large increases in index volatility are not only driven by stocks moving more closely together but increasingly by the individual stocks themselves becoming much more volatile.