Why A Historic Surge in the VIX Wasn’T the Signal Investors Thought It Was

Stocks

Summary:

Any market-timing signals gleaned from the move should be taken with a grain of salt, strategist says…

Investors might be reading too much into last week's historic surge in the Cboe Volatility Index, better known as the VIX or Wall Street's "fear gauge."

Instead of signaling widespread panic, the VIX's dalliance with crisis levels may have had more to do with a quirk in how the index is calculated, Wall Street strategists said. As a result, any market-timing signals investors had gleaned from the move are likely useless, according to Peter Tchir, chief macroeconomic strategist at Academy Securities.

"I think the VIX 65 print is a garbage piece of data … use it in your investing at your own peril," Tchir said in a report shared with MarketWatch.

Why A Historic Surge in the VIX Wasn’T the Signal Investors Thought It Was_1

To recap: The VIX -12.51% topped 65 at around 8:30 a.m. Eastern time on Aug. 5, capping off its biggest intraday swing on record, according to Dow Jones Market Data. The index had only reached higher levels during the 2008 financial crisis and around the time of the COVID-19 crash in 2020.

At the time, a sense of fear was palpable across markets: Japanese stocks had just seen their biggest daily drop since 1987, and S&P 500 futures were down 4.4% as traders grappled with U.S. recession worries and the unwinding of a popular yen carry trade.

Amid the tumult, Tchir and others latched on to the notion that the VIX move still seemed large relative to where stocks were trading. Tchir ultimately concluded that liquidity issues in the options market had likely distorted readings of the index.

One indication that the jump in the VIX might not be reflective of a commensurate surge in demand for hedges could be found in VIX futures, Tchir said. The front-month VIX futures contract didn't rise nearly as much as the VIX itself, calling into question the move in the index.

Tchir ultimately zeroed in on a more likely culprit. As markets tumbled, options dealers had adjusted bid-ask spreads in some of the most illiquid S&P 500 options, he concluded. This appeared to have an outsize impact on the level of the index, even though relatively few trades in the options used to determine the level of the VIX had actually taken place.

A team of Bank of America analysts arrived at a similar conclusion in a report shared with MarketWatch on Tuesday.

In the report, the BofA team pushed back on popular explanations for the jump in the VIX — like the notion that it had been driven by the unwinding of speculative "short volatility" bets, which typically pay off if the VIX falls or remains low.

After taking a closer look at the tape, the BofA team concluded that a few trades in illiquid out-of-the-money S&P 500 options likely had a major impact on bid-ask spreads across the options chain.

The level of the VIX is determined by a mathematical formula that relies on the bid-ask spread of S&P 500 options expiring between 23 days and 37 days out.

Call options represent an agreement to buy a stock at an agreed-upon price before a specified expiration date. They typically represent a bullish position on the part of whoever is holding the option. Puts, meanwhile, represent an agreement to sell at a predetermined price before a predetermined expiration. They can be used to hedge a portfolio against losses, or they can represent outright bearish bets.

An option contract is considered out of the money when the strike price is below the level where the market is currently trading, in the case of a call — or above it, in the case of a put.

Finally, the VIX quickly moved lower once Wall Street had opened for trading, helping to support the theory that liquidity issues were behind its premarket jump, the BofA team said.

U.S. and Japanese stocks have already clawed back their losses from early last week. But both Tchir and the BofA team said the fact that investors didn't see a genuine washout means stocks could be vulnerable to more volatility in the coming weeks.

The historically volatile months of September and October could once again prove to be a challenging stretch for markets this year, the BofA team said.

The VIX was on track to finish below 20 on Tuesday, down 49% from its Monday closing high north of 38. The nearly 50% drop in the index since then represents the biggest six-day slide for the VIX on record.

Meanwhile, the S&P 500 1.68% and Nasdaq Composite 2.43% were poised to climb for a fourth consecutive day, while remaining on track for their biggest four-day jump since November.

Source: MarketWatch

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Why A Historic Surge in the VIX Wasn’T the Signal Investors Thought It Was

Source: MarketWatch

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