As a wild week came to an end, many investors were looking to the options market for clues about where stocks might be headed next.
Some found clues may sit with the Cboe Volatility Index VIX. The “fear gauge” saw its biggest intraday swing ever on Monday when it briefly topped 65, according to FactSet data. It since reversed much of this jump, and finished Friday around 20, just above its long-term average of about 19.5, FactSet data showed.
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Among other things, the VIX is seen as a barometer of investor hedging activity in the options market. It is based on trading in S&P 500 options due to expire in a month.
Some strategists, including a team at BNP Paribas, said the index’s outsize surge this week could imply that stocks likely overreacted to a handful of disappointing reports about the state of the U.S. economy and labor market.
The tumult may have had more to do with the unwind of crowded positions in derivatives markets — as well as the yen carry trade, which has received part of the blame for Monday’s selloff — than shifting economic fundamentals, the team said.
Typically, surges in the VIX of the magnitude seen on Monday have coincided with genuine crises. The 2008 financial crisis and COVID-19 crash in March 2020 have been two examples.
If there was be a silver lining to the week’s volatility, it could be that these types of “high velocity” crashes tend to repair themselves more quickly. Whereas selloffs driven by fundamental issues like a slowing economy take longer to play out.
VIX sees huge ‘beta’ to S&P 500
As stocks tumbled, the VIX exploded higher, moving far in excess of the S&P 500’s more than 3% drop.
The BNP team said VIX beta — which gauges the degree of the outsize move in the VIX — surged to its highest level since 2022 on a rolling one-month basis. Others said that the VIX’s rise on Monday was among the most aggressive they had ever seen relative to the decline in the S&P 500.
“To date, we suggest that this crash has over-extended based on the newsflow. We would characterize this correction, at least so far, as more similar to Volmageddon or Black Monday than a recession,” the team said in a report shared with MarketWatch.
Option-selling funds played a role
Exchange-traded funds and other investment vehicles that buy and sell options have exploded in popularity in recent years. Most of these funds will sell options backed by their holdings of stocks, pocketing the premium. This caps their potential upside return in exchange for downside protection.
Options traders pay an upfront premium to buy an options contract. By selling contracts, these funds can use the premiums they collect to boost their returns.
For a while now, Wall Street strategists like Nomura’s Charlie McElligott and others have warned that the option-selling strategies employed by these funds had helped to suppress volatility, setting markets up for a potentially violent correction.
That appears to have finally happened on Monday. As McElligott explained in commentary shared with MarketWatch on Friday, many sophisticated traders who employ leverage to amplify their returns — whether it is through the yen carry trade, or through “short volatility” or momentum-related strategies — rely on the VIX and other volatility gauges as key inputs to their risk models.
Lower implied volatility gives them the all-clear to pile on more leverage. As McElligott likes to say: “volatility is the exposure toggle.” In other words, a low VIX can lead traders to increase their risky bets.
As stocks slumped, options dealers scrambling to hedge their exposure may have helped to amplify the drop.
Now, as traders start to re-establish bullish bets with an aim to take advantage of a rebound, options dealers could quickly return to helping stabilize markets, the BNP team said.
The S&P 500 SPX erased virtually all of its losses from earlier in the week ahead on Friday, although it still logged a fourth-straight week in the red. The Nasdaq Composite COMP fell for a fourth week as well.
The Dow Jones Industrial Average DJIA fell for a second week.
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