Fear Is Everywhere in Volatility Market Even as the VIX Retreats

The Cboe Volatility Index may have just wiped out the pandemic-induced doom and gloom, but Munich money managers Daniel Danon and Tobias Knecht are fretting over the warning signs still flashing across the stock market’s underbelly.

The recent decline in the Wall Street fear gauge to pre-virus levels belies the “tension beneath the calm” within the volatility landscape, according to the traders at Assenagon GmbH with 27 billion euros ($32 billion) under management.

“The price for protection against sharp downside moves, sharp correlated moves or for just outright volatility exposure is high,” Danon and Knecht, who specialize in such derivatives strategies, wrote in an email.

The extreme demand for portfolio hedges suggests that all is not well for the U.S. stock bull run, which is already on shaky ground between rising Treasury yields and extended lockdowns. It shows how volatility markets are still on edge one year after the S&P 500 hit rock bottom, according to speculators who bet on price swings.

Fear Is Everywhere in Volatility Market Even as the VIX Retreats

“It does not feel that the volatility risk premium vanished so quickly,” the Assenagon investors said.

For nearly a year after the pandemic crash, the VIX -- which measures implied volatility in S&P 500 options -- remained historically elevated even as stocks boomed to fresh records.

But despite the gauge finally closing under the psychological 20 level over the past week, a deluge of technical indicators show investors are still bidding up downside protection.

Take the skew, which measures how much traders are willing to pay for hedging against steep market drops. The cost for one-year protection on the main U.S. stock benchmark “is at extreme levels over a rather long history,” according to Danon and Knecht.

Ditto two other Wall Street measures of fear: the implied correlation on both the S&P 500 and Nasdaq 100. That’s a sign traders overall reckon individual stocks will move together -- something that tends to happen during selloffs.

The VIX was trading at 21 at 10:10 a.m. in New York, as the S&P 500 Index dropped 0.1%.

Fear Is Everywhere in Volatility Market Even as the VIX Retreats

With demand for hedges still high relative to how much stock prices have actually swung around this year, Pierre de Saab is seeing plenty of nerves out there.

“VIX could come down to 15-18 and still remain expensive versus realized volatility,” said the Geneva-based volatility manager at Dominice & Co.

Between lingering pandemic fears, a lack of short-sellers and rising Treasury yields the VIX term structure also remains unusually steep -- showing traders are anticipating more volatility in the future.

Both the three- and six-month futures contracts cost around 20% more than their historical average, according to Susquehanna International Group LLP.

Fear Is Everywhere in Volatility Market Even as the VIX Retreats

That’s not to say the VIX itself can’t fall further, especially given the strength of technical forces. Funds that adjust their strategies according to a one-year historical window will start to unwind hedges as last March’s mayhem fades from view.

Another source of upward pressure on implied gauges -- fervent call-buying among retail investors -- looks like it is fading.

“I think it’s a matter of time without a true fear- and flows-inducing event that low vol will be back in place -- even if not as stable,” said Colton Loder, managing principal of Cohalo Advisory LLC, an alternative investment firm in Washington.

Yet for all that, the angst flashing in the derivatives landscape right now is historically unusual relative to current VIX levels.

“Although near term volatility has decreased, the scars from Covid likely leave investors hesitant to bring down medium and longer term volatility,” Susquehanna’s Chris Murphy wrote in a note.

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