A specialist trader works on the floor of the New York Stock Exchange (NYSE) in New York City, U.S., October 17, 2022. REUTERS/Brendan McDermid
THE traditional inverse relationship between stocks and options-based measures of implied volatility has broken down in recent weeks, and in some cases is now the weakest in years.
What this portends for stocks going into the end of year is unclear, but given how low volatility is just now, it is reasonable to assume investor demand for protection and hedging will rise.
From the fastest pace of interest rate increases in decades and swirling political uncertainty, to recession risks and a bleak corporate earnings outlook, there are plenty of storms investors should be shielding their stock holdings from.
But they aren’t. There are two possible explanations. One, investors loaded up so heavily on options protection at the start of the year that they gradually unwound these hedges even as the bear market unfolded and stocks fell.
Investors now are basically under hedged. Alternatively, they have cut their risk exposure throughout the brutal year to the point that they are now underweight risky assets.
This is backed up by the recent stampede into cash and defensive nature of broad market positioning.
Afraid of missing out on a year-end rally, investors are now paying a premium for equity “call” options over “puts”.
Benchmark volatility gauges like the VIX index of implied vol on the S&P 500 or the V2TX index of implied volume on euro stocks rise when demand for put options spikes. As investors are mostly by default long equities, they naturally want protection to downside risks, especially in times of uncertainty.
A “put” is an option to sell an asset or index at a given price on a given date in the future, and a “call” is an option to buy at a given price.
The VIX has fallen recently to near a two-month low even as the S&P 500 has surged into the green and lurched back into the red. The correlation between the two, almost always negative, has turned positive on 10 and 15-day measures.
Stefano Pascale, an equity derivatives strategist at Barclays, says investors have lightened their risk exposure rather than roll over the hedges they initially had at the start of the year.
“The pain trade for the market has arguably been to the upside which, all else equal, makes the VIX less reactive when equities fall and more reactive when equities rally,” Pascale said.
This is also playing out across the Atlantic, where the sensitivity of volatility to moves in eurozone equities is at its lowest in 10 years, according to Pascale and his colleagues.
These developments are unusual, especially with the S&P 500 in a bear market and considering the economic and financial storm clouds that are gathering on the horizon.
History shows that the VIX was notably higher during previous bear markets and financial and economic shocks.
Meanwhile, the Chicago Board Options Exchange’s “Skew” Index, which tracks the implied volatility of “out-of-the-money” options on the S&P 500, last week touched the lowest level since 2009 and one of the lowest since its launch in 1990.
It suggests investors are paying the least since 2009 to protect themselves against, or take advantage of, an outsized fall on Wall Street versus an outsized rise.
A low Skew shows a low perceived risk of a rare, hard-to-predict “black swan” event on the horizon that will sideswipe markets.
By mid-October the S&P 500 was down 25% and ripe for a bounce. It closed the month up 8%, its best month since 1976, and although it has been up and down since, investors seem to want to maintain the upward momentum.
In the short term the market has clearly been trading bullishly in response to mediocre news, and not bearishly in response to bad news. But this could quickly turn as the economic and corporate clouds darken.
Citi’s equity strategy team reckons the eighth global earnings recession in the past 50 years is about to begin, and note that the MSCI world index is only pricing in a 5% to 10% earnings contraction.
Even that would be a more benign outcome than the average 31% decline of the previous seven earnings recessions, Citi said.
But the current analyst consensus is for a 5% increase. It would appear that investors are not adequately protected for what lies ahead. — Reuters
Jamie McGeever is a columnist for Reuters. The views expressed here are the writer’s own.
