Is A Dropping VIX Masking Rising "Fear" In Most Other Asset Classes... And Does Hedge Fund SPY Pair-Hedging Explain The Market Melt Up?

Tyler Durden's picture

As the trading year draws to a close, and as the QE2 driven melt up shows little sign of relenting (or breaching the 1,200 S&P level), the ever popular VIX, or "fear index" continues to plumb new depths. For many this is a superficial sign of complacency and lack of risk of any major moves within stocks. However, as BNY's Nicholas Colas demonstrates, this is far from the truth as to what is happening below the surface. While highlighting the grind lower in the VIX, Colas observes that "the options market has been busy pricing in higher levels of perceived risk across a variety of asset classes, most notably investment grade bonds, silver, and emerging markets. In fact, of the 20 asset classes and industrial sectors for which we track risk pricing in the options market, 15 show heightened levels of investor concern for the upcoming 30 day period." How does Colas explain this remarkable divergence? "I am tempted to say that the sector IVs are actually better representatives of the market’s take on future volatility, and the lower expected volatility of the market as a whole comes from macro investors who think the next month will be smooth sailing. Conversely, those traders who use sector ETFs and their options to hedge specific single stock positions see a different and potentially more volatile story developing." We tend to agree with the second explanation, which also leads to another surprising conclusion... 

As most hedge funds now tend to hedge idiosyncratic risk using broad systemic hedges, most notably the SPY, which continues to be the most shorted (and "longed") hedge fund ETF, which, due to its being the most actively traded (or, some would say, churned) security by volume on US capital markets, in turn feeds the HFT relay to force robots to believe that due to daily pressure pushing the key market ETF higher or lower, the prevailing move in stocks should be higher (via forward feedback loops), when in fact hedge funds are shifting increasingly more bearish (short individual stocks, and net SPY buying) thereby explaining the constant move higher in stocks, and lower in teh VIX. Is hedge fund pair trade hedging (now that everyone is terrified of shorting individual stocks as pair trade hedges) with ETFs solely responsible for the daily move higher? We will likely not know with certainty until a forensic analysis of the market can be conducted after the next mega-crash, although recent observations of market moves lead us to believe that this could be one possible explanation. Then again with all modern-day feedback loops which have no formal start or end, in a market in which one wing-flipping butterfly can cause a market flash crash, who really knows...

We hope to revisit this most fascinating emerging feedback loop theory at a later date, but for now, here are Colas' complete observations on why anyone trading purely on a dropping VIX may be in for a rude awakening.

If the Boys Want to Fight, You’d Better Let Em

Only 36 shopping days left until Christmas, and 29 more trading days left in 2010. The S&P 500 is up some 7.5% year to date, and the most recent prices on the CBOE VIX Index come in just shy of 20. The options specialists at ConvergEx don’t like it when I call that the “Fear Index,” but since that’s the shorthand many on the Street use to describe the VIX we’ll use it here. Just for today – I promise. I will go back to “Expected price volatility/cost of insurance” with the next installment of these monthly assessments of the options market and risk pricing.

The bottom line on the VIX is that both in terms of its absolute level and general trend, there just doesn’t seem to be any real fear in the U.S. equity markets. If the market is metaphorically a gathering place of buyers and sellers, then the current environment resembles a Seattle coffee shop. A quiet murmuring crowd. The low hiss of the milk foamer. Maybe someone playing Jewel covers on an acoustic guitar in the corner. The VIX is below 20 and has been moving lower in a calm collected manner since May. Over the last month, for example, the Fear Index (sorry, options guys) has come in from 20.6 to less than 19 yesterday.

Other parts of the options market, however, look more like a roadside bar on Hells Angels initiation night. The VIX is down over the last month, yes, but just look at our accompanying graph with 19 other industrial sectors and asset classes. That exhibit shows what is essentially the “VIX of…” these groups. You will notice that expected volatility in large cap U.S. stocks (S&P 500) is in the distinct minority when it comes to declining levels of fear. Here are a few examples of where the options market clearly sees more reason for near term concern:

Among asset classes outside of stocks, the options market has seen incremental concern in Investment Grade Bonds, Silver, Emerging Markets, Junk Bonds, International Stocks, and Gold. You might at this point ask how we calculate these changes. The answer is that the proliferation of Exchange Traded Funds tracking diverse asset classes has led to an active listed options market for these securities and the asset types they track. From there you simply calculate the Implied Volatility for the options associated with the ETF in question. We use www.ivolatility.com as our source for the data presented here.

Most of the sectors within the S&P 500 are seeing higher levels of expected near term volatility, even though the VIX itself is down. This includes Energy, Consumer Staples, Materials, Tech, Health Care and Consumer Discretionary. When you think about it, this is an oddball observation. How can the expected volatility of the index decline if the individual sector IVs are increasing? Low price correlations might explain the difference, except correlations are quite high at the moment. I am tempted to say that the sector IVs are actually better  representatives of the market’s take on future volatility, and the lower expected volatility of the market as a whole comes from macro investors who think the next month will be smooth sailing. Conversely, those traders who use sector ETFs and their options to hedge specific single stock positions see a different and potentially more volatile story developing.

The last point I would like to make is on Gold. There has been some concern of late that the yellow metal has topped out for the year and perhaps for good. Looking at the data from the options market, the “Gold VIX” doesn’t show either extreme complacency or extreme worry. It is exactly in the middle of its historical range of 15-25, with a current reading of 20. Maybe that puts Gold in the coffee shop rather than the roadside bar, but it does seem that the risk pricing in the options market does not support any overly positive or negative call.