Did Volatility Traders Freak Out Enough To Bottom?



by Dana Lyons

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Yesterday saw a huge spike in stock volatility expectations – but was it enough for a bottom?

One of the great, unintended benefits of financial innovation is the creation of additional market indicators based on the new streams of data. A perfect example is the explosion of stock market-based volatility products. While even the purveyors of such volatility products would likely concede there are enormous potential pockets of risk bubbling up based on investors’ behavior related to the products, that behavior can serve as a valuable indication of investor sentiment – especially when it pertains to fear.

Given the subdued volatility over the past few years, selling volatility has been a profitable strategy probably 95% of the time. It has made for long periods of comfort and complacency for volatility sellers. The problem is, when volatility, i.e., risk, does appear, volatility expectations tend to rise infinitely faster than they dropped. And the theoretically unlimited upside means that those folks who are short volatility are forced to cover, or risk losing everything. These high-fear events are often indicative of some type of a market bottom. Take yesterday’s action, for example.

For the last 6 weeks, we’ve witnessed a historically low level of volatility expectations in the stock market. Thus, staggered throughout those 6 weeks, there were countless numbers of traders taking the opportunity to short volatility. However, when stock market volatility struck yesterday, most all of those traders who sidled into volatility shorts at different times all rushed for the exit at the same time. That’s why the signals are more obvious related to the fear side. If 1000 folks sneak past you one at a time, you may not notice them; however, if they all run by at once, it sets off alarm bells.

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Let’s put graphical context to this. The term structure of the S&P 500 Volatility Indices refers to the varying durations involved. For example, the indicator of expectations over the next month is called the VIX. And the 3-month indicator is called the VXV.

During good, calm markets, near-term volatility expectations usually remain low, even at an extreme, versus those longer out. In the case of the VIX:VXV ratio, a reading below 0.8 is typically considered a calm or complacent environment. When volatility rises, traders tend to flock to the near-term contracts faster than those further out. Thus, the VIX:VXV ratio typically jumps. A reading over 1.0 is often considered extreme.

Yesterday, the VIX:VXV ratio jumped from 0.82 to 0.99, i.e., from near a low extreme to near a high extreme. That is an indication of everybody running for the exit at the same time. In this case, it was a historically large jump. More specifically, at 20%, it was the 2nd largest jump in the history of the VIX:VXV ratio, trailing only the day of the 2010 Flash Crash (VXV inception was in 2007).

Here are the daily changes in the VIX:VXV ratio for the last 10 years versus the S&P 500, highlighting those daily jumps of more than 15%.

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So is this 20% jump in the VIX term structure an all-clear sign for stocks? If spikes in volatility expectations are reliable indicators of fear – and potentially market bottoms – this should be a step in the right direction. But is it enough?

In a premium post at The Lyons Share, we’ll address that question by studying previous, similar occurrences and the market’s subsequent performance. The results do seem to suggest a pattern to the market’s behavior following such trader behavior.

 

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