Fear of a January Repeat Arise After Breakdown of Stocks-VIX Correlation

(Bloomberg) -- U.S. stocks have been on a tear over the past week. So why has the market’s “fear gauge” barely budged?

The stickiness of the Cboe Volatility Index, which tracks the 30-day implied volatility of the S&P 500 Index based on out-of-the-money options, eerily echoes conditions that prevailed in early 2018.

Stocks and implied volatility move in the opposite direction about 80 percent of the time, but the VIX crept higher in the second half of January even as the S&P 500 hit record highs. That’s happening again, with the short-term negative relationship between the two deteriorating to its weakest levels of the year.

Fear of a January Repeat Arise After Breakdown of Stocks-VIX Correlation

The S&P 500’s actual performance helps explain the VIX’s out-of-character rise Monday. Measured 30-day swings in the benchmark have been rising since stocks broke out of a monthlong range and calm July sessions dropped out of the calculations. The rally that’s pushed the S&P 500 up 3.4 percent since mid-August outpaced expectations on the options market, prompting traders to reassess the likelihood for downside moves.

“When you rally this quickly, the downside options would be too cheap if the volatility didn’t adjust up,” said Pravit Chintawongvanich, equity derivatives strategist at Wells Fargo Securities. Stocks and the VIX tend to move in the opposite direction because higher equities usually reflect a reduction in risk premium, he added.

Read More: Options Traders Press Record S&P 500 Run

The similarities to January’s run-up, on the surface, bode ill for risk assets. Implied volatility had a record one-day spike on Feb. 5, which sparked market turmoil and sent U.S. equities into a correction.

Naufal Sanaullah, chief macro strategist at EIA All Weather Alpha Partners, suggested that the phenomenon was a function of dealers rushing to cover short call exposure in S&P 500 options. After that buying power is exhausted, with stocks at technically stretched levels, the stage would be set for near-term downside in U.S. equities.

The S&P 500 rose 0.6 percent to a record 2,914 as of 3:56 p.m. in New York Wednesday. The VIX slipped to 12.19, halting a two-day advance.

“We do see signals suggesting we could soon see a snapback correction to around 2,875-2,880, and for a squeeze in the VIX in such a scenario,” he said. “We continue to observe low liquidity depth and outperformance in names driven by retail flows.”

Even if the latest stock rally falters, Sanaullah says, the damage to the S&P 500 and the VIX likely won’t be as severe as in January.

The VIX futures curve is both higher and relatively steeper at the front end than it was in January, and exchange-traded products that let retail investors bet on market calm no longer have as much power to contribute to negative feedback loops through end-of-day rebalancing activity.

Fear of a January Repeat Arise After Breakdown of Stocks-VIX Correlation

These changes in the curve, as well as the level of spot VIX, suggest there’s less complacency than had prevailed in January -- so it might take a bigger shock this time around to catalyze a swift, steep selloff.

“I’m not worried about this action,” said Dave Roberts, a Washington-based independent trader of volatility options and products, highlighting the differences in the curve. He also noted a change in the relationship between the VIX and the implied volatility of volatility itself -- known as VVIX. “What is a bit interesting is how VVIX continues to reach pre-VIX explosion levels in the low 90s, but VIX really can’t get back to the 9 or 10 level.”

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