Prescient Volatility Markets Temper Sell-Off in U.S. Stocks

(Bloomberg) -- Volatility markets didn’t know a U.S. airstrike that roiled the Middle East was coming. But they were prepared for a jolt to an American equity market that could seemingly do no wrong.

The Cboe Volatility Index, which measures expected swings in stock values, traded at a substantial premium to actual equity gyrations, pointing to lingering apprehension among investors that the good times wouldn’t last. The premium effectively served a built-in cushion that allowed volatility markets to digest Friday’s sell-off without anything resembling a full-scale freak-out.

The VIX rose as much as 3.7 points Friday before paring the advance to 1. At 13.39, it remains four points below its average of the 10-year bull market. The S&P 500 was down 0.6% as of 10:45 a.m. in New York, more than 1 percentage point better than where overnight futures action implied. The relatively muted response in the VIX for a such market sell-off also reinforced that short-volatility positioning in VIX futures -- where investors bet against rising stock swings -- was not as widespread as feared.

“The volatility term structure makes it difficult for a real selling feedback loop to develop, absent a strong and immediate Iranian retaliation,” said Naufal Sanaullah, chief macro strategist at EIA All Weather Alpha Partners. “But for now, we are primarily expecting a relatively orderly dip in indexes, as a little bit of froth gets reset.”

Part of the credit for that goes to volatility traders. As one of the best years for American equities in the past decade came to a close, the VIX was trading at a 7.6 point premium to the realized 20-day gyrations of the S&P 500. The front-month VIX future was trading at an even wider gap to recent history. Together, the data showed rising fear that a shock could hit risk assets, whether the feared rise of stress in the repo market or something unknowable like the assassination of Iran’s most powerful general.

Tensions between the U.S. and Iran may be prone to back-and-forth flare ups throughout the spring and summer, Sanaullah added. That potentially offers better entry points for bets on heightened geopolitical risk premiums. For now, the strategist is adopting a combination of short volatility and short U.S. stock indexes position in the aftermath of the initial market response.

The current scenario contrasts sharply with early 2018, when the VIX entered the year trading below 10 and at a premium of less than 4 to the S&P 500’s realized volatility for the first half of the month, leaving markets more vulnerable to the abrupt reversal that ensued.

To contact the reporter on this story: Luke Kawa in New York at lkawa@bloomberg.net

To contact the editors responsible for this story: Jeremy Herron at jherron8@bloomberg.net, Dave Liedtka

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