Using Convexity to Understand Market Sentiment

Learning conceptual applications of convexity in options to better understand markets.

Transcript

00:00 Volatility indices like CME Group CVOL are insightful indicators of market sentiment.

00:05 CVOL measures 30-day forward volatility across all option strike prices in key futures markets and includes a metric called convexity.

00:14 Convexity is the ratio of CVOL to the market's at-the-money implied volatility indicating excess variancein out-of-the-money options compared to at-the-money options.

00:24 Higher convexity suggests greater market uncertainty.

00:32 To understand what convexity can tell us about market sentiment, let's look at three examples of convexity in action.

00:38 First, US treasury futures.

00:41 Daily convexity across the yield curve from 2013 to 2022 highlights two key points.

00:48 Convexity tends to be more sensitive in the shorter end of the yield curve, thus, greater variance as yields may be moving higher or lower.

00:55 In 2013, it was the taper tantrum when the Fed was reducing their quantitative easing, causing treasury markets to move.

01:02 In 2020 and 2021, due to COVID-19, supply chain shocks and higher inflation saw increased convexity.

01:09 As of early 2025, convexity fluctuated around its historical average of 1.06.

01:16 However, in April, changes in US trade policies cause convexity and treasury yields to spike.

01:22 Since then, convexity has remained high, suggesting greater uncertainty in future treasury yields.

01:27 While 30-year convexity remains stable, two-year convexity is increasing, aligning with historical patterns.

01:34 Second, British pound futures.

01:36 On June 23, 2016, the UK voted to leave the EU.

01:40 Leading up to the referendum, the British pound was relatively stable at around 1.43.

01:45 However, convexity declined to a low of 0.96, indicating the market was focused on at-the-money strike prices.

01:53 On the day of the vote, convexity spiked, showing increased uncertainty and more activity out-of-the-money options.

01:59 Third, euro futures.

02:01 The convexity of euro futures has been cycling around 1.05, its long-term mean and median since October 2013.

02:09 In August 2024, convexity increased as the options market was uncertain about euros direction.

02:15 As the euro futures bottomed in January 2025, convexity initially spiked but has since reverted to the mean, suggesting the market perceives less uncertainty in the foreseeable future.

02:27 The next time you see CVOL convexity increase, think about what it may imply about market sentiment.

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Transcript