3 Signs Volatility Has Peaked

Options are cheap relative to the potential directional movement in stocks

Senior Vice President of Research
Aug 12, 2019 at 8:21 AM
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"In other words, the option forces related to big put open interest strikes will not be in play if the 290 strike is breached between now and expiration Friday on Aug. 16, reducing the odds of a sharp sell-off driven in part by the options market."
-- Monday Morning Outlook, August 5, 2019

Famous last words, huh? In last Monday’s trading, the SPDR S&P 500 ETF (SPY - 291.62) dropped below the 290 strike, coincident the round 2,900 century mark on the S&P 500 Index (SPX - 2,918.65), and by day’s end found itself bottoming just above the 280 strike. While option-related, delta-hedge selling was not at work, there were clearly other sellers looking to quickly exit the market. Suffice it to say that it could have been worse, as put open interest "magnets" below the 280 strike in the soon-to-expire standard August series are bigger than those below the 290 strike, implying an intraday break of the 280 strike could have led to delta-hedge selling.

"Potential support lies just below on other benchmarks that we follow, as well:

  1. The SPX's 80-day moving average is sitting at 2,915, with the round 2,900 level just below this trendline.
  2. The RUT's converging 160-day and 200-day moving averages sit at 1,515, with the round 1,500 century mark just below.
  3. Finally, the MID is sitting right above the round 1,900 century mark -- a brief support area in early May before 1,800 marked a bottom in late May."

-- Monday Morning Outlook, August 5, 2019

Although it was far from pretty, the SPX enters expiration week above 2,900, a potential level of support that I discussed last week. Moreover, the Russell 2000 Index (RUT - 1,513.04) and S&P 400 Midcap Index (MID - 1,901.33) come into the week above round-number support at 1,500 and 1,900, respectively. 

Trade headlines continue to captivate market participants, with the market reacting to the various punches and counter-punches between President Donald Trump and China. At the same time, less aggressive punches sent stocks sharply from weekly or intraday lows -- i.e. - China denying it is manipulating its currency as a weapon in the trade war, after allowing its currency to weaken to a decade-long low, or news that the White House clarified it is only the federal government not doing business with Huawei, not private companies.

The uncertainty has sent gold soaring and bond yields sharply lower, as market participants seek safety amid heightened concerns that the Fed will be too slow to adjust to perceptions that a trade war amid slowing world economic growth will disrupt the long expansion we have experienced.

And as a CNBC contributor said last week, “The VIX (Cboe Volatility Index - 17.97) should be higher to account for the uncertainty.” Put another way, options are cheap relative to the potential directional movement in stocks, which is yet another reason to use options in this environment.

"[I]n the futures market, historically wrong-way large speculators on VIX futures (as measured by the weekly Commitments of Traders reports) are nearing an extreme net short position, which raises the risk of a volatility explosion ... Option speculators are seeing higher volatility in the days ahead, as is evidenced by the ratio of buy-to-open call volume relative to buy-to-open put volume on VIX futures during the past 20 days...

"As for the VIX itself, it comes into the week trading below 12.71, which is the level 50% below its 2018 close of 25.42. The 12-13 area has been a VIX floor in 2019, so from this perspective, there is growing risk of a slight (to sharp) uptick in volatility in the immediate days ahead.
-- Monday Morning Outlook, July 29, 2019


In late July, I cautioned you about the possibility of a rise in volatility, as the VIX was trading at its 2019 floor coincident with Large Speculators -- who have been wrong on every major move in volatility -- were in an extreme net short position. At last Monday’s close, the VIX was at 24.59, or roughly double its 2019 closing low, and, in fact, doubling from the July 26 close of 12.16.

I stated on Twitter, there's a possibility of that close being a key peak, due to the VIX’s tendency to peak or trough at round-number percentages above or below a key low. Moreover, the VIX has tended to respect round-number year-to-date percentage gains, as is evident by the lows this year being 50% below the 2018 close, and the highs being around the 2018 close of 25.42 (see the chart below).

MMO 1 VIX daily chart

Another reason that I think a volatility peak is in place, at least for the time being, comes from historical perspective. Albeit there have been only four occurrences in the past when the VIX has doubled in eight days or less, like it did from late July into last week, but it has never been higher from three days out to 252 days. Again, this is a small sample size, which adds risk to this call, but it does follow the historical mean-reverting script of the VIX. 

The VIX again closed just below the 18 level on Friday, which is still encouraging for bulls. But as we learned last Monday, this is not a forecast for Monday's trading. Additionally, it is still above its 200-day moving average, which is at 17.16, and bulls might want to await a close below this moving average for an “all clear.”

A few other reasons to bet that a volatility peak is in place:

1. Remember the relentless call buying on VIX options ahead of the VIX explosion? That has changed, as the 10-day ratio of VIX call buying to VIX put buying has plummeted from 10 ahead of the sharp rise in the VIX, to a current ratio of 5. Moreover, as I noted internally on Friday, note that the largest VIX open interest changes from Thursday into Friday were on the put side.

MMOC chart 2 VIX OI

Data courtesy of TradeAlert

2. Large Speculators on VIX futures were in major covering mode last week, with net short positions as of Tuesday at the lowest since mid-February, which was a good time to be long stocks and short volatility.

"[A] plethora of August call open interest begins at the 17 strike and grows through the 20 strike, where there are more than 400,000 contracts. In most instances, 80-90% of VIX call open interest expires worthless -- so if you are playing history, you would not expect to see a ton of upside in the August VIX futures contract, which closed at 17.74 on Friday."
-- Monday Morning Outlook, August 5, 2019

3. As I said last week, historically, roughly 80-90% of VIX call open interest expires worthless, as many calls that are bought are far out of the money, since the VIX makes huge percentage moves in short periods and traders or hedgers are seeking major leverage if such a move occurs. Despite August VIX futures moving as high as 24.81 last week, the contract closed at 18.68 on Friday. This means many of the August 21-expiration calls are in a position to expire worthless, per the open interest configuration chart below.

The headlines that are moving markets are admittedly not predictable, but the volatility has created opportunities in the short term and perhaps opportunities for the months ahead. As I have reminded readers before and will do so again, the environment continues to make options an attractive vehicle relative to stocks, as you are able to put less money in the market to deal with the enormous uncertainty, but the leverage allows you to realize meaningful profits. 


Todd Salamone is Schaeffer's Senior V.P. of Research.

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