One of the main features of the year 2022 is the spot/vol (by strike) dynamics of S&P 500 (see graph below), a valid question is: ๐ช๐๐๐ก ๐ช๐๐๐ ๐ง๐๐๐ง ๐๐ก๐?
The very specific 2022 dynamics are due to the massive size of short VKO (Vol Knockout) puts in the market. This position means that dealers get longer and longer SPX variance as the market goes down (as the moneyness of the put increases). Two main events may change those dynamics.
๐ญ/ ๐ง๐ต๐ฒ ๐ป๐ฎ๐๐๐ฟ๐ฎ๐น ๐ฒ๐ ๐ฝ๐ถ๐ฟ๐ ๐ผ๐ณ ๐๐ต๐ผ๐๐ฒ ๐ฉ๐๐ข ๐ฝ๐๐๐.
VKO puts have a maturity of 3 months to 18 months. The ones that were issued end of 2021 are deeply in the money. So are the source of a lot of variance selling. As they come to maturity, they will give big payouts to the buyers since the realised vol over the life of those puts has been very moderate and below the KO level. Once they matured, even new issuance will have less impact on the dynamics, unless the S&P keeps falling so that the โinventory of dollar moneynessโ is maintained constant.
๐ฎ/ ๐ง๐ต๐ฒ ๐ฐ๐ฟ๐ฎ๐๐ต!
If S&P500 crashes, then most VKO Puts will be KOed, and the dealers will need to buy back their short variance hedge in panic mode. That would mean a violent reset of the full S&P vol surface, and the end of the spot down / vol down dynamics. It is obviously a scenario that neither the buyers of the VKO puts nor the dealers want to see!
