U.S. stocks roared back on Thursday and Friday of last week. The nearly 50 point move higher in the S&P 500 had traders turning attention from possible support levels on the downside to new highs on the upside. What a difference a couple days make.
Meanwhile, the speed and volatility of both the move lower on Monday of last week (2.3% lower), and the subsequent rise at the end of the week (two 1.25% moves higher), is a change in character for the broader market. In fact, 10 day realized volatility in the S&P 500 is now at a 1 year high after those large moves last week, even as 30 day implied volatility fell back to the lower end of the range:
10 day realized volatility has not stayed above 20 for any significant period of time during the past 2 years. Each bout of high realized volatility was quickly replaced by another period of calm, and generally rising stock prices.
However, in today’s case, implied volatility has fallen so quickly that the spread between 10 day realized and 30 day implied is the largest it has been for most of the past 2 years. Traders have been trained to sell any spike in implied volatility. Bloomberg had an article this morning indicating just how zealously VIX traders have played for a lower VIX over the past week:
Ownership of puts on the VIX has risen 23 percent since Jan. 21, Bloomberg data show. Open interest in calls fell 14 percent to 7.2 million after reaching an all-time high of 8.4 million three weeks ago.
Bets on a decline in volatility also pushed record money into an exchange-traded note that rises in value as stock-market swings narrow. Assets in the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) doubled over the past two weeks to $810 million on Feb. 7, according to data compiled by Bloomberg. The ETN, known by its ticker XIV, rallied 16 percent to $30.33 in the last two trading days.
Yet, when I look at the risk-reward of the VIX at 15, with realized volatility still above 20, the risk-reward seems much better playing for VIX upside rather than VIX downside, especially given the asymmetric nature of the VIX when it is already in the mid-teens.
Traders’ conditioning is likely the main reason for this large disconnect. Protection trades like the one Dan and CC laid out on Friday are good ways to take advantage of cheap implied volatility. We are generally long premium in many of our single stock options positions, too, another reflection of our view that implied volatility looks cheap considering recent realized volatility.