VIX1D Signal Points to Potential Short-Term Weakness in S&P 500

VIX1D Signal Points to Potential Short-Term Weakness in S&P 500 

A signal based on the VIX, specifically for zero-days-to-expiry (0DTE) options, has triggered, marking an event that has historically coincided with short-term underperformance in the S&P 500. These 0DTE options have become a dominant force in the market, accounting for nearly half of daily trading volumes. To track the implied volatility of these options, the VIX1D index was developed. Its behavior typically involves rising throughout the trading day and then resetting to a lower level at the opening of the next session.

This pattern can largely be attributed to the volatility risk premium, a phenomenon where implied volatility tends to exceed realized volatility. However, there are exceptions. Occasionally, the VIX1D opens at a higher level than it closed on the previous day. Such an instance occurred on Tuesday.

Historically, when this higher open occurs, it has often been a precursor to periods of short-term resistance for equities. Data suggests that the S&P 500 tends to experience negative average performance over the five- and ten-day periods following such signals. Moreover, over the subsequent 30- and 100-day periods, the index underperforms its mean return. These patterns suggest that when the signal triggers, it marks a potential shift in market dynamics, favoring caution for the near term.

Interestingly, since the last occurrence of this signal, the S&P 500 has managed a two-day return of 0.5%, which is above its average two-day return of 0.2% since June 2023, the approximate starting point for trading in the VIX1D index. While this short-term strength bucks the broader historical trend, if past patterns are any indication, the S&P is likely to face weaker returns over the next week or so.

The market's current environment offers no shortage of reasons for potential resistance in equities. One notable factor, highlighted recently, is the sharp increase in the cost of equity financing. Dealer balance sheets are under strain due to a flood of Treasury issuance, which has tightened financial conditions. This strain has implications for leverage and liquidity. A sudden reduction or withdrawal of leverage for financing represents a significant near-term risk for the stock market.

In summary, the VIX1D signal serves as a reminder of the potential for turbulence in the equity markets. While the S&P's recent resilience is notable, historical patterns suggest that this strength may be short-lived, with the index likely encountering headwinds in the days ahead.