New Vol Regime

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September 2, 2020: All-time highest VIX on a day with the S&P 500 touching the highest level ever.

Equity Market Volatility Divergence

Strange times indeed. This week we observed two spectacular divergences. First, single-name equity option activity relative to indices was near all-time, historic extremes. Second, Nasdaq volatility (VXN) traded at a multi-year premium to the CBOE VIX. What is going on here? This post is from August 28, the latest update is here. 

Nasdaq Volatility Trading Very Rich to the S&P 500
With the Nasdaq QQQs up close to 40% this year, there are lots of gains to protect.  Nasdaq vol has been trading very expensive relative to the VIX. Investors are paying up for protection.

Climax Points

Think of bull and bear market capitulation climax points. At the end of a bear’s mauling, dozens if not hundreds of rallies have failed. Long, exhaustive bear markets break the hope and spirit of more and more investors – until the point of maximum capitulation. There is NO one left to sell, think March 2009. Each failed rally delivers deeper losses to the market participants and every one of the “fast money” tourists have run for the hills. All that’s left is an empty meadow, the genesis of a new bull market is born.

Now, let us think of the beast inside a great bull. Dozens if not hundreds of dips have been bought. With each victory, fast money rookies share their battle stories with more and more friends at cocktail parties. Tourists arrive, busload after busload empty into the market, it’s all good, “this is easy.” With each triumphant buy of the dip, investor confidence turns into a dark shade of hubris and more and more capital pours in. Why not, the mad mob is playing with the house’s money. Now think of 100 hedge funds, all up 3% for the month. Why not take 1% of those gains and buy calls on the largest, highest momentum equities. Worst case you end up 2% for the month, best case you deliver 5%, after all, you take home at least 20% of the profits. One conclusion, month-end (Aug 31) / quarter-end (Sept 30) is about to get very interesting.

August 2020

The first 20-ish days of the month were the quietest in a long time. If we look at ten-day, realized equity market volatility, it plunged to nearly 6 vol, 2020’s nadir. On the other hand, this week as month-end drew closer – we experienced two, 1% trading range days with close to forty handle swings in the S&P 500. For sure, someone is monetizing gains.

VIX Up – S&P Up
On Wednesday and Thursday this week, the  Chicago Board Options Exchange’s CBOE Volatility Index (VIX) was more than 5% higher each day, with the S&P 500 up both of those days. How rare is this? Very. We could only find ten days in the last decade with the S&P up 1% with the VIX closing higher. This is especially rare with the market at all-time highs. In a healthy bull market at its best levels, the VIX should be in the low teens, NOT the lows 20s. 

Two Month vs. 8 Month VIX Futures Contracts
One of our 21 Lehman Systemic Risk Indicators are found in the trading spread between the two and 8-month VIX futures options contracts. To keep this as simple as possible, all we are doing here is measuring the cost of protection. How much more expensive is buying short term vs. long term insurance? The above data is mindblowing. This week, the cost to buy the two-month VIX future reached nearly 5 handles more than the eight-month contract. Elephants leave footprints. When large hedge funds need or want to pay-up for short term protection from a market crash that is one thing, BUT the price they are paying this week is VERY extreme with a market at all-time highs. As you can see above, the 2-8 spread is wider today than nearly every financial panic in the last five years. In a healthy, “risk-on” (where risk is being put on) bull market – this spread should be in “contango” – the two-month VIX futures contract should be ALOT cheaper than the 8-month variety. 

 Paying Up for Upside Risk

Over the past few weeks, there has been a massive buyer in the market of Technology upside calls and call spreads across a basket of names including ADBE, AMZN, FB, CRM, MSFT, GOOGL, and NFLX. Our friends at Citadel calculate, over $1 BILLION of premium spent and upwards of $20B in notional through strike – this is arguably some of the largest single stock-flow we’ve seen in years, they noted. We agree someone is playing with House Money, and they’re rolling large.

“The average daily options contracts traded in NDX stocks to rise from ~4mm/day average in April to ~5.5mm/day average in August (a 38% jump in volume).  Given this group of 7 stocks accounts for a ~40% weighting in the NDX, the outsized volatility buying in the single names is having an impact at the Index level.  So why are Vols moving yesterday/today when this call buying has been taking place for weeks?  Yesterday CRM, one of the names we have seen outsized flow, rallied 26% on earnings – a less than ideal outcome for those short volatility from all the call buying.  As the street got trapped being short vol, other names in the basket saw 3-4 standard deviation moves higher as well – yesterday FB rallied 8% (a 3 standard deviation move), NFLX rallied 11% (a 4 standard deviation move), and ADBE rallied 9% (a 3 standard deviation move).  The most natural place to hedge being short single name Tech volatility is through buying NDX volatility.  As such, there has been a flood of NDX volatility buyers with NDX vols up about 4 vol points in 2 trading days. And if NDX volatility is going up, SPX volatility/VIX will eventually go up too.” Citadel

What are the conclusions? What does this tell us about the path forward? What other instances of this occurrence have we seen historically? Email for our full report.