There is a phenomenon called “Warning/Alarm Fatigue” where people can become desensitized to warnings and risk. This is commonly associated with weather forecasts in which people may ignore alerts if they are too frequent, or have been recently incorrect. We’ve all experienced times when meteorologists predict major storms, only to find a bit of rain. However, there are often tragic consequences to not heeding these warnings.
A meteorologist’s role is to analyze complex models, and then to share a forecast. If there is the right mix of storms and warm ocean water over the Atlantic, a hurricane may form. Sometimes, predictions of catastrophe fall flat and we experience gratitude for the good fortune coupled with some frustration over spent time preparing for a storm that never came. Other times, events like Hurricane Katrine or Ida can strike, and ignoring the warnings can be devastating.
In this way, market forecasting is similar to predicting the weather. Both professions have models which portray the likely outcome given current conditions. Warm water and a thunderstorm doesn’t mean a hurricane forms, but cold water and no wind puts the odds at zero. As more variables line up, the greater the odds of a hurricane.
Our approach at SpotGamma is akin to making weather predictions. We look critically at the Situational Evidence and Historical Statistics, and our approach involves analyzing millions of data points every day and then putting these insights into clear charts and commentary for our subscribers to highlight both opportunities and risks. While we won’t always be right about what we think might happen, we will always give you a clear view of what could happen based on our analysis and this has proved extremely valuable for our community (see our warnings ahead of the Covid-Crash).
Very importantly, right now, we see the potential for a major pullback and feel compelled to share our insights with you.
The Current Volatility Landscape
Below we’ve plotted the implied volatility (IV) level of 25 delta SPY options. The days left until these options expire are color coded, with near term options colored purple scaling to longer dated options (30 days out) shown in yellow.
Historically implied volatility for the S&P500 is in contango with near term options holding a lower implied volatility than longer dated options. You can see this in the chart below – the yellow dots are typically higher than the purple dots.
However, during stock market crashes the implied volatility of near term options rises over that of longer dated options (backwardation). This is most clear in March of ’20, in which there is a huge divergence between ultra-high short term IV and very high longer dated IV.
S&P500 25 delta option implied volatility
A few other interesting things are apparent from the chart above. First, while longer dated implied volatility has been trending steadily lower, is still higher than it was before the March ’20 Covid-Crash. Interestingly though, very short dated IV is now trading back to pre-crash levels. You can see this by comparing the red boxes above. Furthermore, you could read this as: “traders have some trepidation 1 month out, but they have no worries about tomorrow.”
When we step back, this decline in implied volatility makes sense. 1 month realized volatility (that is how much the market has moved) at ~7% is roughly at its lower bound going back to 2012. In other words – over the past month the market’s been quiet.
After a large volatility spike, subsequent volatility spikes seem to have less amplitude. To place this into context, consider when you bounce a rubber ball: the first bounce is large and each following bounce has less energy. Similarly, options traders seek to take advantage of spikes in volatility by selling equity/index put options and/or VIX futures, which holds in additional volatility.
Over time as volatility pushes towards a lower bound, traders more aggressively sell volatility, causing a reflexive effect by dampening the size of volatility spikes (as seen below). Eventually, this forces volatility into a wedge in which traders are selling volatility at rates which imply negligible market returns.
S&P500 Realized Volatility from spglobal.com
The big takeaway is that selling these options works until it doesn’t…and just like picking up nickels in front of a steamroller, at some point, you run the risk of getting crushed if a single trade goes against you. This dynamic can setup a catastrophic response if the trade reverses.
Lets take an example. On 9/7 the Friday SPX at-the-money put was trading at an IV of 10.3%, with a value of ~$19. This indicates that traders are forecasting a daily move of just 0.65%. This indicates that traders are anticipating very quiet trading days.
What is exceptional is if instead of having this muted response, the markets instead pullback sharply, resulting in more than a 1% drawdown. In this situation, you see a small shift higher in implied volatility can double losses, as the put value explodes to ~$50.
How does this happen? As we have explained in our videos when traders by and large sell put options, that leaves dealers with large long put positions. As a result, these dealers must hedge their options exposure by buying stock. . This becomes a reflexive feedback loop – where dealers push up the market via hedging, as traders take bets shorting options against below-average market returns. The result is a very perilous setup where a reversal can be sudden and the unwinding violent.
When an event then takes place that causes markets to selloff, these traders must scramble to cover. This is because when you are short puts you must buy them back, and this reflexively then forces dealers to sell their hedges and at times short stock forcing the market lower, and volatility higher. This squeezes the incremental volatility seller and can rapidly expand volatility leading to a very sharp and sudden decline.
The Takeaway
SpotGamma believes that the conditions are in place for a very violent sell-off – something akin to September of ’20 when the market declined ~10% over 3 weeks. This could place the S&P somewhere near 4000, which we see as support because of substantial options positions at that strike. This is not a call based on fundamentals, but instead on the positioning in the options market. We think that traders have become acclimated to selling very short term options for increasingly smaller returns and there are some catalysts ahead which may blow these traders out.
Specifically we note:
-
VIX Options Expiration on 9/15/21
-
Index/Equity Options Expiration on 9/17/21
-
FOMC Meeting on 9/22/21
-
Quarterly Index Options Expiration on 9/30/21
The timing of these events are the key piece. The expiration events (as to why they matter go here) may lead to a tick higher in volatility, at which point some reflexive volatility selling may enter. However, because the FOMC meeting occurs right after expiration, not only may be there be less short volatility supply – there may be a sustained volatility bid. It is the combination and timing of these events which provides the conditions for a large spike in volatility & market drawdown.
As a member of our community, we respect your decision to protect your portfolio or let your gains ride. We just feel it’s our duty to let you know…Its hurricane season.
Addendum
We wanted to address one aspect of volatility landscape as a more advanced topic. Specifically we want to make note of the fact that longer dated volatility is quite elevated. This is depicted in the chart below which shows the VIX volatility term structure. You can see that spot VIX (green line) is well below that of longer dated futures.
You can see a similar phenomenon in our top chart of the S&P IV by comparing how compressed the data points are in the left red box, vs right box.
This spread between short & long dated IV indicates that traders are holding longer dated hedges which we think protects the market from a catastrophic decline. Our view of a sharp drawdown is based on short dated volatility expanding which would place the IV term structure into backwardation. The bid to longer dated volatility may mute the decline which is why we look for a “September ’20” style move versus a more catastrophic move.
When the entire IV term structure is compressed that sets the stage for a “volmegeddon” or “march ’20” style blowout.
