Drop in Nasdaq Volatility Index Is Latest Sign of Options Froth

(Bloomberg) -- On a day when technology shares shook as hard as they have in six months, a measure of volatility on the same set of stocks did a strange thing: it went down.

With the Nasdaq 100 swooning 4.8% to cap a three-day, 11% correction, a gauge of index turbulence that is partly a reflection of options prices also dropped -- another in a series of unified moves that has now lingered for two weeks. Normally, the two gauges move in the opposite direction, as declining stocks buttress expectations of a rougher road ahead.

The rare harmonized decrease is more evidence of unusual positioning in derivatives markets, where both speculation and hedging are running to extremes and big institutions are putting billions of dollars on the line. As has been reported over the past week, both retail and professional investors have loaded up on call contracts, or bets that stocks will rise. With the Nasdaq in free fall, enthusiasm for that trade appears to be diminishing.

“It is a function of both reduced call pressure as well as the fact that the market appears to be pretty well hedged coming into this,” Michael Purves, chief executive officer of Tallbacken Capital Advisors LLC, wrote in email, describing as “an educated guess” any generalization about volatility markets. “The premium of implied to realized was very high so now we have realized catching up with implied.”

Unprecedented call volume drove some of the upside, though puts were also elevated. Take the Invesco QQQ Trust, an ETF tracking the Nasdaq 100. As of last Wednesday, the day before the market rout began, about 3.3 million bullish contracts were outstanding on the fund, up 43% from three months ago, data compiled by Bloomberg show. Over the same stretch, its bearish bets increased by only 26%.

The Cboe NDX Volatility Index (VXN) fell 1.7%, staging a second straight synchronized decline with the Nasdaq 100. The concerted move extended an unusual string of days where the options-implied volatility gauge went in the same direction as the underlying index, mostly up before this month.

While a panoply of theories exist on why this might happen, traders mostly cited two things on Tuesday. One, the frenzy buying of calls that pushed up VXN along with the Nasdaq in August is abating with tech darlings from Apple Inc. to Tesla Inc. plunging.

Second, gains that occurred in VXN last week, which reflected demand for puts as investors sought to hedge against losses. Indeed, heading into this month’s rout, the VNX was at the highest level since 2003 relative to the VIX, a similar gauge for the S&P 500. Now that the Nasdaq has fallen into a correction, options traders are betting that any downside is likely to be limited, according to Steve Sosnick, chief strategist at Interactive Brokers.

“Traders are not too concerned about the current drop going further than 10% from here,” Sosnick said, citing flattening implied volatility in the Nasdaq 100 puts over the past week. It “could be the belief in of ‘Fed put.’ It also puts a lid on VXN,” he said.

The irony is, anyone who had purchased VXN at a higher level to hedge against any decline in the Nasdaq is now hurting instead. That may have have fueled further selling in both, according to Cem Karsan, founder of Aegea Capital Management LLC, a volatility fund in Chicago.

“Many people dramatically overextended into momentum and attempted to hedge with vol,” Karsan said. “Now that vol is massively underperforming they are losing on both sides of the trade which is making the losses worse and forcing liquidation on both sides of the trade.”

To Kris Sidial, vice president at Ambrus Group, a volatility fund, the united retreat in both the VXN and the Nasdaq is part of a normal process after euphoric stock buying was accompanied by heavy protection.

“When this pre-hedging takes place, it is difficult to get the market to fall apart,” Sidial said. “You don’t get the velocity of selling because guys are already hedged. So when things ‘normalize’ you have an interesting dynamic where spot is down or flat and vol is down.”

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