As is expected during a major market shock, options spreads on SPX, SPY and VIX widened out substantially. But were they really as extreme as they appeared in the days following the volatility shock of February 5, 2018? Measured in simple price terms, option bid-ask spreads showed extreme widening, with 2-day increases exceeding 700% in SPY, and an over 400% increase in SPX. Price measures also showed persistent widening, even out to March 1. A more nuanced analysis however, reveals a more rational outcome in line with expectations given an initial shock of high volatility followed by increasing stability.
The data presented here is what we call Hanweck Volume Weighted Relative Liquidity (VWRL), meaning the measure adjusts for the price of the option so there is no bias due to higher or lower prices. This normalizes spreads compared to conventional measures in say pennies. Additionally we have volume weighted the spreads to place more weight on the quote spreads associated with options that traded more.
Using this measure, what we see is that SPX spreads increased 43% on February 5, and then another 34% on the next day February 6, for a 2 day change of 92%. Even when normalized by our measures, SPX spreads almost doubled during this period of unexpectedly high volatility.
SPY spreads showed a much greater increase. Digging a little deeper, some of this effect is due to a starting point of a tighter SPY bid-ask spread in a "normal" period (see comparison of SPX and SPY spreads on February 1). SPY showed the largest increase of 125% on February 6, and a corresponding 2 day increase of 162% increase as spreads went from a narrow 11% to a much wider 28.6%. Interestingly both SPX and SPY spreads ultimately landed at roughly 25% of midpoint option price on February 6.
Chart 1: Hanweck Volume Weighted Relative Liquidity (VWRL) for SPY vs. SPX*
VIX options showed milder increases. Some of this is because VIX is less liquid than the other two instruments in normal periods so it had a wider starting point, similar to SPX, but VIX seemed to maintain a relatively narrower spread on the endpoint here of February 6. It expanded to roughly 20% of midpoint option price, showing a 2 day increase in spread of 41%. Interestingly it was slower to return to pre-shock levels and maintained a wider bid-ask spread even on February 12. Perhaps this arose from persistent structural changes in the VIX related to the ETF market.
Chart 2: Hanweck Volume Weighted Relative Liquidity for VIX
Now we see that by February 12, spreads began narrowing back dramatically. So one week post-vol shock, SPX remained 34% wider than it started, SPY was 9.7% wider than where it started, and VIX 35% greater than the starting point. SPY with market-making across exchanges started off with spreads significantly narrower than SPX. But one week after the volatility shock episode, SPY also stayed wider.
Looking at the data one month post-shock, we see that both SPY and SPX showed expected returns to normal trading by March 1, in fact with spreads in both cases moving slightly tighter than their February 1 starting points.
SPY options had better VWRL measured liquidity prior to the shock of 11% (compared to 13% for SPX). SPY options suffered a liquidity shock through the recent episode that looked greater than SPX in some part because of SPY's lower starting point. At its worst point, SPX spreads widened to 25% and SPY to 28.6% (92% and 162% increases in spread respectively from best to worst). As liquidity recovered by March 1, the differential in liquidity between SPX and SPY narrowed, and SPY returned to being more slightly more liquid (SPY at 10.2% and SPX at 11.1%). In our view, liquidity behaved as one would expect through a major market shock coming out of a period of extended low volatility. There was increased risk aversion in market-making as one would expect, but the markets continued to function well. The episode is instructive to those looking to assess liquidity risk through historic shock episodes.
* A Hanweck liquidity measure, Volume Weighted Relative Liquidity, that measures bid-ask spread as a percentage of option mid-point price. This measure normalizes for different priced options, and places greater weight on those spreads with greater trading volume. This measures spreads with the most meaningful economic impact.
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