Market Calm – Material or Mirage?
The CBOE Volatility Index, known as the VIX, serves as Wall Street's "fear gauge." It projects the expected market volatility for the next 30 days based on S&P 500 index options. The recent low levels of VIX have prompted discussions among investors and analysts, questioning whether this tranquillity is authentic or merely a fleeting phase. Did the market simply take an extra CBD gummy?
Since March 2020, implied equity market volatility has decreased despite tighter monetary policy and increased geopolitical tensions. This is perplexing, as one would anticipate higher volatility under such uncertain conditions, yet the VIX is subdued, hovering around 14.01, significantly below its five-year and long-term averages of 21.5 and 19.9, respectively.
One possible cause is the increase in short-volatility strategies, which involve selling equity options or shorting VIX-based derivatives to profit from low volatility. This sale suppresses the option prices used in VIX calculations. Additionally, the popularity of zero-days-to-expiry (0DTE) options, now over 50% of SPX options trading volume, contributes to this trend. Market makers hedge their 0DTE positions with longer-dated options, indirectly impacting the VIX, although some argue that their effect is minimal, as they serve as hedges.
Moreover, the growing use of yield-enhancing structured products, such as covered calls, in which investors buy the S&P 500 Index and sell a one-month call option, helps suppress volatility. The hedging by dealers of these options often stabilises volatility; they buy when the index falls and sell when it rises.
However, low VIX levels may mask the potential market risks. For example, the divergence between low implied equity market volatility and elevated implied volatility in interest rate markets (as indicated by the MOVE index) suggests underappreciated financial stability risk. In addition, the mean-reverting nature of the VIX suggests that it could spike suddenly in response to unexpected events or economic shock. The correlation between low VIX levels and market complacency is well-documented, and history suggests that periods of low volatility often precede sharp market corrections.
A low VIX implies a calm market, but investors should remain alert, as the factors suppressing the VIX could reverse quickly, potentially leading to a sharp increase in volatility. In finance, apparent tranquillity may be misleading. Remember, "When the VIX is low, look out below!" suggests that a current market calm might precede turmoil, so before getting too comfortable with those CBD gummies, remember that the market's calm can still be the prelude to a storm.
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