Tuesday, March 21, 2023
- Equity market uncertainty is running high as investors assess the fallout from the latest banking failures. However, implied volatility measured by the Chicago Board Options Exchange (CBOE) Volatility Index (VIX) has been relatively subdued.
- The lack of upside in implied volatility has been surprising, especially considering the S&P 500 traded down as much as 23% after the VIX reached its high watermark last year. Even the recent bank failures barely pushed the VIX above 30 last week on an intraday basis.
- The proliferation of zero days to expiration option activity over the last year has likely limited VIX demand. These options provide an alternative to the VIX for hedging known event risk.
- Record-high money market fund assets are also likely limiting demand for the VIX as there are fewer positions to hedge. Money market funds recently topped $5 trillion, surpassing the pandemic-era highs.
Volatility has increased this month as banking sector turmoil shook investor sentiment. The sequential failures of Silicon Valley Bank (SVB) and Signature Bank (SBNY), along with the recent bailout of Credit Suisse (CS), have elevated uncertainty over contagion risk—and with increased uncertainty comes increased fear.
One way to measure fear in equity markets is through the CBOE VIX, or as some call it, the ‘fear gauge,’ which provides a real-time update of expectations for volatility on the S&P 500 over the next 30 days. The VIX represents implied volatility derived from the aggregate values of a weighted basket of S&P 500 puts and calls over a range of strike prices. Generally, a rising VIX is associated with increased fear in the marketplace and falling stock prices, while a declining VIX is associated with decreased investor fear and rising stock prices. In addition to speculative positioning, the VIX is commonly used to hedge long positions.
The chart below highlights the spot VIX and the difference between 1-month and 3-month VIX futures. For reference, spot VIX refers to the real-time calculation of the VIX, as the actual index is not traded—only VIX futures.
As highlighted, the VIX has been making lower highs since its January 24, 2022 intraday high of 38.94. The lack of upside in implied volatility has been surprising, especially considering the S&P 500 traded down as much as 23% after the VIX reached its high watermark last year. Even the recent bank failures barely pushed the VIX above 30 last week on an intraday basis.
Underwhelming VIX demand is evident when comparing the VIX futures curve to other periods when near-term market uncertainty was elevated. Last week, the VIX curve went into backwardation, meaning shorter-term VIX contracts became more expensive than longer-term contracts. While this represents an increase in near-term demand for hedging, the backwardation period last week was brief compared to other backwardation periods. In addition, the VIX only closed around 26 during each day of backwardation last week, well below the average closing VIX price of 31.8 on previous days when the curve was in backwardation (since May 2004).
The muted VIX response to equity market selling pressure becomes even more apparent when comparing last year’s drawdown on the S&P 500 to other comparable drawdown periods. We analyzed VIX levels for all trading days when the S&P 500 was in a drawdown ranging from 18.5% to 28.5% (range based on +/- 5% levels from last year’s 23.5% drawdown from January to June). The bar chart below is bifurcated between all periods from 1990-2021 and 2022.
Why does the VIX Appear Less Fearful?
One potential driver of limited upside in the VIX is the increased popularity of zero days to expiration option contracts, or what many investors call “0DTE.” As the name implies, these are call or put options with less than one day until expiration. For the S&P 500, the CBOE’s recent addition of Tuesday and Thursday weekly expirations to already listed Monday, Wednesday, and Friday contracts meant investors could trade 0DTE contracts daily on the index. It is important to note, a 0DTE option could be a longer-term option that has reached its final day of expiration or it could be a specific option only listed for a single trading day.
Volume has climbed steadily since last April and May when the new Tuesday and Thursday contracts were added to the market. Most of the increase in volume was due to 0DTE trading activity. According to the CBOE, the average daily volume for S&P 500 options with zero days to expiration jumped 83% in 2022 and comprised 43% of overall S&P 500 option volumes in December alone.
Another reason why VIX upside has been relatively subdued could simply be due to fewer positions to hedge. With short-term rates surging over the last year and economic uncertainty running high, money market funds took in record inflows. According to the Investment Company Institute (ICI), assets in money market funds are now over $5 trillion, recently surpassing the peak pandemic levels.
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