Rapid VIX Drop Signals Potential Market Turbulence Ahead

Rapid VIX Drop Signals Potential Market Turbulence Ahead 

The rapid decline of the VIX, both in absolute terms and compared to volatility across different asset classes, sets the stage for more market turbulence.

It's almost as if the recent market turmoil never happened. Despite a nearly 10% drop in recent weeks, the S&P 500 was close to reaching a new high on Wednesday.

What's particularly striking is that during this downturn, the VIX experienced its most significant spike ever, made worse by illiquidity, with the non-traded VIX hitting levels far above the traded futures.

Nonetheless, the extreme movement in the VIX indicated greater tail risks, making the S&P's ~10% drop feel more severe than it might seem when viewed on a chart in the future.

Volatility is typically episodic, so it's noteworthy how quickly it has decreased.

While not yet at its lowest point, the VIX's decline, especially in comparison to other measures, is significant.

The VIX has now dropped below realized volatility, a rare occurrence, having been lower relative to realized volatility only 1% of the time since 1990.

When compared to cross-asset volatility, including bonds, FX, and credit, the VIX, after its spike, is now almost as low as it has been in the past two decades.

The initial surge in the VIX seemed largely driven by a decline in out-of-the-money call skew.

A major contributor to positive gamma is traders selling calls to earn premiums, but when risks increase, this demand fades. This change in hedging behavior by option dealers can reduce volatility less effectively or even exacerbate it as gamma turns negative.

Gamma dipped into negative territory in late July/early August but has since rebounded.

The VIX's rise signaled much of the market's decline, but it was the volatility in shorter-dated indexes, like the VIX1D, that provided an earlier warning. This could happen again.

High volatility discourages reckless carry-trading and poor decision-making, while calm volatility can encourage risky behavior that leads to market upheaval. The rapid decline of the VIX1D and the VIX increases the likelihood of a repeat of the recent market shock.