Unraveling the Market Mystery: Examining the Decline in Volatility and Record-Low Skew
Over the weekend, we closely examined a significant market trend that has puzzled many in recent times: the continuous decline in implied volatility (known as VIX) along with historically low skew levels.
The discussion has evolved over the past year. Initially, some, notably Marko Kolanovic from JPMorgan, attributed the VIX drop to 0DTE derivatives, foreseeing a potential market crash akin to Volmageddon. However, this prediction hasn't materialized. Recently, JPMorgan's strategist, building upon the research of derivatives analyst Bram Kaplan, shifted focus to call overwriting as the cause of artificially low volatility, which aligns with the pattern of option-based ETF gamma supply and the VIX decline.
Similar to the skepticism during the 0DTE concerns raised by Marko, now Mandy Xu, a derivatives expert at Cboe, contradicts the ETF hypothesis. She argues that if ETFs were truly responsible, the price of bullish stock options would be lower, indicating their impact is modest. Xu suggests that subdued volatility is more a result of the current stable economic conditions rather than ETF activity.
The fixation on the VIX on Wall Street persists, especially given the extended period of below-average readings despite economic uncertainties. Various theories attempt to explain this calm, including individual stock movements offsetting each other and the prevalence of short-dated options trading.
Regarding options trading strategies, Xu notes that while many ETFs target options with a 30% chance of being profitable, their impact should be reflected in SPX skew, which remains deep. Despite concerns about collapsing skews, there's no shortage of explanations, ranging from market dynamics to unprecedented volatility patterns.
Goldman Sachs' derivatives trader Brian Garrett adds to the debate, pointing out that volatility during market rallies has been significantly higher than during sell-offs, an unusual occurrence. This indicates a market orientation towards expecting VIX declines and leveraging options for bullish bets.
In essence, the market seems fixated on betting on further market uptrends rather than hedging against downside risks, with options being used as leverage tools. This sentiment is reinforced by recent dovish signals from the Fed and record-high stock prices, implying a belief that buying the dip strategy will always prevail.