Surging interest rates (and hawkish-er FedSpeak) and soaring geopolitical risk concerns have not been good to US equity markets over the past month with stocks puking at their fastest pace in years (though as we noted previously, not seeing the usual VIX spike that accompanies the pain).
Option markets have taken an opposite stance to stocks: a sharp drop in put-vs.-call implied volatility skew has boosted the price of out-of-the-money call options.
The S&P 500 index skew has fallen sharply during the last month - more aggressively than other global indices’ skew has, and in sharp contrast to rising single stock skew.
Lower skew implies that market participants do not see implied vol rising quickly should the sell-off continue, and also likely results from investors buying calls as a right-tail hedge for under-allocated portfolios.
In fact, as Goldman's Rocky Fishman points out in his latest note, skew has dropped dramatically... just as it did in late 2018 (shortly before Fed Chair Powell folded and reversed his hawkish stance to rescue stocks).
3-month, 25-delta skew has dropped from close to its all-time high to the bottom of its 10-year range.
The drop in SPX skew has been dramatic - but not substantially more severe than the drop that happened around the Dec-2018 selloff, which was a similar-magnitude sell-off in which volatility similarly underperformed - though skew is at a level rarely seen in the last seven years of exuberance...
The Index Volatility Strategist sees a number of factors contributing to the drop in skew:
Spot sell-off. With the SPX now 16% below its peak, many downside put strikes are at levels that would correspond to a historic market drawdown, vs. call strikes at levels corresponding to a partial recovery toward highs. As a result, investors see a given % upside as more likely to be reached now than they did prior to the sell-off, vs. severe further downside as somewhat less likely.
High vol. With implied vol already high, and higher than the magnitude of the sell-off would indicate it should be, it is hard for markets to price in even higher vol should markets sell off. The VIX’s lack of new highs despite the SPX finding new lows shows that markets are already hesitant to continually mark up implied volatility as much as skew would indicate they should.
Light positioning. One driver of the long-term upward-trend in skew has been the growth in systematic asset allocation strategies, including managed volatility funds. With vol already high and equities in a sustained downward trend, these strategies do not hold substantial equity risk, so there is minimal concern about further de-risking going forward (and their re-allocation represents an upside driver). Light positioning from the broader investor base also leaves less de-allocation should markets continue to fall.
Vol underperforming during the recent sequential selloff. The VIX and longer-dated metrics of implied volatility are at levels that are historically very high and beyond the typical range of realized volatility, even in typical recessions. As a result, the VIX has not been hitting new highs, even as the spot SPX has hit new lows. This implicitly leaves skew underperforming (high skew would imply vol continues to rise as the SPX sells off), and investors have consequently marked down implied skew.
To take advantage of this somewhat extreme backdrop (and position for a limited rebound in equity markets), Fishman recommends overlaying long equity positions with 1x2 call spreads: Buy a 18-Nov 4050-strike call (1.0% out-of-the-money) vs sell two 4325-strike (7.9% out-of-the-money) calls for near-zero net premium (indic. mid as of 3:51 PM NY time on 13-May, ref. spot 4009). The strategy should be profitable at all spot levels between 4050 and 4600... though faces unlimited losses if the S&P tops 4600.
In the short-term, as we detailed earlier, there is enormous front-week (short) $Delta which serves as “fuel for a melt-up” into VIXpery tomorrow and Op-Ex Friday, as collapsing iVol (UX1 -7.2 Vols from the Thursday high to last) not only creates the Dealer “short hedge” cover...
As SpotGamma notes, this setup feels a lot like that of late April in which the market launched higher into VIX expiration and a chunky April OPEX.
Below is a plot of that timeline, and as you can see the VIX dropped sharply (+ strong S&P rally) on Tuesday the 19th leading to a VIX low on the 9AM Wednesday VIX settlement. Markets pinned on Thursday, and sharply reverted all their gains on OPEX Friday (full analysis here).
So what will happen this time? Brent from SpotGamma is joined by Imran Lakha of Options Inisght to discuss the positioning around the May OpEx...