By: Steve Sosnick, Chief Strategist at Interactive Brokers
Last Thursday – two trading days ago – the CBOE Volatility Index (VIX) had a 20 handle. Now it is flirting with 31. That is a stunning move in a very short period. Traders turned from relatively complacent to nervous literally almost overnight.
Over the past few months, VIX has established a wide trading range. As the graph below shows, the index has tended to bottom in the high teens or 20 range while being prone to sharp spikes above 30 when the S&P 500 Index (SPX) retreated. The pattern may be repeating once again.
VIX Index, Five Month Daily Bars with 20 Day Moving Average (blue)
Source: Interactive Brokers
Even a cursory read of the graph reveals a few key points. First, it can be very treacherous to be short VIX when sentiment turns. If you had shorted VIX around 20, what were you hoping to gain? A point or two? Maybe three? Yet it is quite easy to lose 10. That is a lousy risk/reward ratio. It’s one thing to sell VIX above 30 – your risk/reward can be relatively balanced. At 20, not so much.
Second, what were traders thinking when they were pricing VIX at 20 last week? It is important to remember exactly what VIX is designed to measure. Here is the definition from the CBOE’s website:
“… the VIX Index is intended to provide an instantaneous measure of how much the market thinks the S&P 500 Index will fluctuate in the 30 days from the time of each tick of the VIX Index.”
I found it odd that traders were relatively sanguine about volatility over the coming 30 days when we have so many “known unknowns’ ‘ occurring in just the next two weeks. The relative complacency was something I alluded to in a radio interview done before the Asian market opening on Thursday. Even after Netflix’s (NFLX) earnings debacle, traders seemed unconcerned about the prospect of several other megacap tech earnings that are expected this week. We have Microsoft (MSFT) and Alphabet (GOOG, GOOGL) after the close tomorrow, Meta Platforms (FB) on Wednesday, and Apple (AAPL) and Amazon (AMZN) on Thursday. Those alone constitute about 40% of the NASDAQ 100 Index (NDX) and about 20% of SPX. That doesn’t include the numerous other heavily weighted index stocks scheduled to report in the coming days. A significant earnings miss in any of the aforementioned stocks could have a deleterious effect on investor sentiment. Traders knew this just as well last week as they did this week, but chose to look past that risk until well after NFLX’s drop was priced in.
If this week’s earnings aren’t enough to concern investors, we have an FOMC meeting next Wednesday. Markets turned abruptly lower on Thursday after Federal Reserve Chair Powell signaled a 50-basis point hike at this meeting. It’s not as though he and other Fed governors signaled something otherwise, except for some who floated the possibility of even more aggressive hikes. Yet that was like a splash of cold water on the collective face of the market. Among other things, we still don’t know the pace of future hikes and the likelihood and possible timing for the start of Fed balance sheet reduction. Bear in mind that the Fed has talked a big game but has so far done very little in actuality. A 25-basis point hike is tiny amidst the current inflationary backdrop, and the balance sheet continues to grow despite the cessation of open market bond purchases (though the growth is at a slower pace). It seems that traders didn’t like being reminded of that.
It is entirely possible that sentiment ahead of the Fed meeting. Equities had a tendency toward lower closes in the days following an FOMC meeting when the Fed was relentlessly accommodative in the wake of Covid. Now that their rhetoric is more negative, the pattern has reversed. But with the Fed meeting over a week away, we can only speculate what is truly priced into the market’s mentality. As of now it appears that increasingly dire scenarios are being priced in.
As I look at today’s market activity, with major index futures bouncing around by as much as 5 or 10 points at a time, it is obvious that liquidity has diminished markedly. Under this type of scenario, it is important for traders and investors to utilize strategies that avoid consuming expensive liquidity and instead get paid for providing it. In other words, utilize limit orders that allow you to buy on the bid and sell on the offer whenever possible, rather than using order types that force you to cross large bid/ask spreads. This is what market-makers do during volatile periods, and it can be helpful to trade with them, rather than against them.
This post first appeared on April 25, 2022 on the Traders’ Insight blog
PHOTO CREDIT:https://www.shutterstock.com/g/Roman+Samborskyi
Via SHUTTERSTOCK
DISCLOSURE
Investing involves risk, including the possible loss of principal. Diversification does not ensure a profit nor guarantee against a loss.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information is not intended to be individual or personalized investment or tax advice and should not be used for trading purposes. Please consult a financial advisor or tax professional for more information regarding your investment and/or tax situation.
The Standard and Poor’s 500, or simply the S&P 500, is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the United States. VIX is the ticker symbol and the popular name for the Chicago Board Options Exchange’s CBOE Volatility Index, a popular measure of the stock market’s expectation of volatility based on S&P 500 index options. Investors cannot invest directly into indexes.
