Socially Acceptable Volatility Strikes Again

Market swings are back! But this time, investors seem oddly comfortable with the turbulence. We break down why “socially acceptable volatility” has returned, what options markets are signaling, and how headlines, sentiment and skew are shaping the next move.

Summary – IBKR Podcasts Ep. 368

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Andrew Wilkinson

Welcome everybody to this week’s podcast. My name’s Andrew Wilkinson. I have an incredible team around the table here. Welcome Kevin Davitt, Head of Index Options Content from Nasdaq, Steve Sears, Options Columnist at the Barrons, and Steve Sosnick, who is Interactive Brokers’ Chief Strategist.

Steve Sears

Great to be with you.

Steve Sosnick

Great to be here. Andrew, great to be with this group.

Kevin Davitt

I feel the same way.

Andrew Wilkinson

Very good. Let’s get underway. I wanted to start with Steve Sears.  Now, it’s the week before Easter. It is Wednesday. We’re recording middle of the week.  Last week, stocks looked like they’ve broken down, and a lot of that obviously is due to the Iran war. Has President Donald Trump figured out how to soothe the market with words?

If that’s the case, just how dangerous is that tactic? What do you think?

Steve Sears

I think he most certainly understands exactly what investors want to hear and need to hear, and I think he’s expert at delivering those messages on social media? I can’t recall a time, quite frankly when X, nee Twitter, figured so prominently into the investing playbook.  Is it dangerous? A hundred percent.

Because… I’ve been on a number of briefings with, you know, very senior intelligence and military officials retired, and they speak about Trump’s style of communicating and negotiating as being unpredictable. And there’s one thing that we know, it’s the oldest saw, one of the oldest saws on the street:

The market can handle good news. The market can handle bad news. It can’t handle uncertainty. Well, Trump seems to have flipped that on its side. And so, the uncertainty is that the highest that I can recall it since the Global Financial Crisis [GFC]. However, you can see what happened with stocks yesterday.  We had an enormously bullish move across all markets.

Andrew Wilkinson

Steve imagine if the if the Iranians had Twitter or something too.

Steve Sears

They do. And the Speaker of Iran’s Parliament has been treating up pretty decent investment advice, believe it or not. He started yesterday and early before the open. He encouraged people not to give into the fear of missing out, which is a topic that we’ve discussed many times over the years here in this forum. So it is, it’s a complete battle of words. You know, just before, I believe it was the declaration of World War I, in the, I believe it was the US Senate, one of our elected officials said, “Truth is the first casualty in war.”  And it gets trotted out from time to time almost whenever we have conflict. This conflict is no different. And I think about that as I watched the stock surge amidst this battle of words. Last week I called it the “Battle of Tweets.”

Andrew Wilkinson

Steve Sonick, what are your thoughts here?  You know, the Cboe VIX hasn’t gone up through the roof.  What’s happening with volatility and broad stocks?

Steve Sosnick

In general, volatility is higher. I mean, as you’d expect, we are more volatile. So, it would be, you know, crazy if we didn’t see measures of volatility rise. So that in and of itself, you know, that’s reflecting the reality, right? I mean, remember what VIX is and is not.If you’ve read my stuff before, and I assume if you’re watching this podcast, you have, you’ve seen the phrase, “VIX is not a fear gauge, but it plays one on TV.” But so, with that in mind, VIX is not, there is no explicit sentiment measure in VIX. It is derived from S&P 500 futures, or in the case of VXN, derived from Nasdaq 100 options, I should say. And this is the market’s best estimate of volatility over the coming 30 days. The standard best predictor of volatility over the coming 30 days is what have you done for me lately? And what we have, what we’ve had is big intraday moves, right? I mean, we had a giant move yesterday.  We had a giant move on Friday. We had a big move on Thursday. Why shouldn’t volatility measures be elevated?

Steve Sears

Well, I wanna let you take the opposite side here if I can.  VIX is elevated long-term, average is 19, it’s now about 25. It peaked around 30. It’s the best fear gauge that we probably have out there, that people can understand. But I’m very curious to get Kevin’s views on this, I think VIX would be materially higher were it not for the fact that there’s an enormous amount of index options being sold on a daily basis to generate yield.

Kevin Davitt

That point is one that I think has been brought front and center over the shift in duration and interest toward the front end of the curve over the past couple of years. I’m a little bit reluctant to take the other side of both of you on this point, or actually I’ll just point out that from a realized volatility standpoint this year thus far has not been unusual.

So, I would point out that the Nasdaq 100 has realized volatility around 18 and a half calendar year to date, and the S&P’s are realizing like 14 1/2. And those are not unusual numbers. From a realized volatility standpoint, the market has priced in greater volatility. And when we talk about the moves yesterday, I believe the close over close move yesterday was the biggest we’ve seen since like fall last year. 

We’ve seen 1% moves here and there, but a dearth of 2% moves. And for VIX to continue to realize something in the neighborhood, I’m sorry to express, the market needs to realize higher volatility. And this is one of the points we were batting around before we kicked off. But the impact of skew or what Index skew has been telling us, and there have been some shifts when you look at downside volatility relative to upside in recent weeks, and I’d love to get your guys’ take on what that might be telling investors.

Steve Sosnick

That actually was where I was leading to, and I’m glad we took this detour, but that really was an important point that I wanted to get to. Part of the thing about VIX and the VIX measurement is it’s not strictly…. It will always trade above historical or realized.

And the reason for that is because it includes wings. And includes extreme wings. And I know Nasdaq, you know, tried to use VOLQ, which I think was actually in many ways a more sensible measure. You know, limiting the number of strikes up and down. But regardless, if there’s a bid and an option that’s 20% outta the money, it gets, as long as there’s a non-zero bid, it gets included in the VIX calculation. And so what happens here is we ‘ve had a big shift, and yes, you’d expect the curve to have a parallel shift upward when volatility increases. You’d expect to see a steeper skew to the downside when you’ve had a series of downside hiccups. We’ve gotten that to some extent, although actually it didn’t really steepen all that much to the downside.

The more interesting part to me is that the curve, which is always described as the Elvis smile — sort of like that sideways, you know, Elvis’ asymmetric smile — is it’s actually gotten a bit more, quite a bit more symmetric. Not a hundred percent, but what we’ve seen is as we’ve gone lower, implied volatilities in upside calls in major indices have increased. And there’s two reasons in my mind for this, and I’d love to bat this around and get your ideas and see if I’m off base, on base or semi.  One theory of mine is it’s FOMO insurance, and that is people remember what happened in last April — which is almost exactly a year ago now –when, you know, we went down after “Liberation Day”.  And I’ll argue the bigger reason we went down then was because the President [Trump] and [Treasury Secretary] Bessent and [Commerce Secretary] Lutnick were seemingly tone deaf about markets, and that was the last thing the market wanted or expected from the administration. Then when they took a more market friendly tone off, we went to the upside. We had a 9% rally and people, you know, it was a face-ripping rally to use the parlance.

And so, people are either speculating on that, or they are doing the sensible thing when you have a downtrend, which is to sell rallies predominantly, rather than buy dips predominantly. But most people are not comfortable trading from the short side and particularly in an environment like this.

So, their insurance was no longer the downside insurance so much, but the upside insurance.  I’m trying to, I think, trying to reconcile those two theories. I think the answer’s probably somewhere in between. And I want you guys to weigh in.

Steve Sears

In my view, I think the answer or the explanation for this is less financial and more societal. I saw news this morning that most Americans can’t gather together $500 to pay for an emergency. They had less than $500 in their bank account. So, what’s happened over the past, you know, 5, 10, 15 years, we’ve seen investing and trading become more like speculative gambling market. And the fear of missing out perhaps is not so much a FOMO virus, but you have to be in the market. And if you came of age post GFC, which is, you know, almost 20 years ago, what do you do? You buy stocks, and stocks are great, but you look at the volumes, which we can remember when it was a big day, when we did a million contracts in options, and I think now it’s like 44 million. So people come in here, not…

Steve Sosnick

We’re almost up to 60 million. I think it went from 15 to 60 in the last five or six years. Insane.

Steve Sears

So, I stand corrected. So, what are you gonna do to play? You’re gonna, you’re gonna buy calls, you’re gonna sell puts. And I think that this distorts volatility within the indexes. And plus, the one thing that we have that we’ve never had before in this market are gigantic options funds run by very sophisticated, smart guys who can come in on the wings and look at various, you know, skews or burps in vol and then take advantage of it and sell it and knock it down or push it up.

Steve Sosnick

But then does that fully explain this sort of rare thing?  We did see this upside skew in Nasdaq as the Mag7 was going crazy, and to some extent, QQQ’s, ’cause you know, at least particularly in individual stock, and I mean, I think that’s Kevin’s bailiwick, so I don’t wanna step on it, but I think that answer is part of it, and I think that’s why there’s this desire for the FOMO insurance.  And just because you can’t miss out. 

We could do two hours of the blurring of the line between gambling and investing at this point, so I’m not gonna dismiss that point at all.

Andrew Wilkinson

Kevin, skew, I’m all shook up, uh huh huh.  What do you think?

Kevin Davitt

This happens to be a point that has captured my attention in recent weeks. I think about relative options exposure, and generally speaking, the moves that we see in index options markets like the Nasdaq 100 typically are very similar to what you see in the S&P’s, but to the point that we have been slicing and dicing here, the cost of a one month, 10% out of the money call option in the Nasdaq and NDX relative to SPX got as cheap as it’s been in roughly five years earlier this month.  It coincided with standard March expiration now, just to put a couple numbers around that, not get too convoluted, typically that option trades at roughly a four point volatility premium to the S&P’s.

It got down to about one and a half. Now in the past week and a half, that vol premium moved back up to five,] a much more normal level that does speak to some sort of behavior where people are concerned about that rebound. The backdrop to this market is very different than the one we saw coming out of  the ChatGPT launch at the end of 2022.

The backdrop here is the Nasdaq 100 fell nearly 12% off the late October highs and is down roughly 9% in the quarter. And so to see markets right size as I think risk reprices faster than it ever has in this environment. The one last point I would make is that the sophistication in the marketplace these days is beyond what I could have ever expected, even just a decade ago.

And there has been a proliferation of these funds that gather significant assets and attention that generally speaking, sell volatility. Now for the most part, they do that systematically as opposed to the type of players that can look at skew and say, “I think there’s opportunity at this point in the distribution,” right?

These funds do things mechanically and that can open opportunities to people that understand the sort of language that we’re using and the dynamics in the market that can shift very quickly.

Andrew Wilkinson

I wanna come back to Steve Sosnick.  Something we were talking about before we started recording, does this market look like 2008 all over again to you?

Steve Sosnick

This part? No. The 2008 stuff you know, that private credit sort of has fallen to the wayside because that was the sexy story, but it’s not nearly as immediately important as a closure of the Strait of Hormuz.   But I did have a very prominent New York-based restructuring attorney, co-head of restructuring at a fairly large New York law firm, say to me over lunch one day, just socially, that this reminded him of 2008 all over again.

Or actually his words were, “You do realize this is 2008 all over again.” You know that’s a pretty extreme statement, but I have to take that with some respect. Because the restructuring people are the first line in all this, right? You know, if you’re gonna have big markdowns, you’re gonna want your debt restructured.

They used to all be bankruptcy attorneys. They don’t like the word, you know, “bankruptcy.” They’ve upgraded their terminology to some extent, which is good because you do want to see them restructured rather than just go right into Chapter 11, or worse Chapter 7. But they’re seeing this and the issue that I have is, I don’t think that private credit is as pervasive as subprime mortgages were because the subprime mortgages at the root of it affected ordinary people.

Private credit, unless the government really has its way and allows us to put them in 401K’s — which actually was literally proposed this week — until then you really don’t have exposure to this asset class. And it’s, I think, $2 trillion out of a much larger financial system. Problem being, trouble occurs at the margins and what we’ve seen is stuff [that should be] marked to market just marked at par because the rules in an opaque, non-tradable market are much looser in terms of marking things than they would be if there was a public source of trading. And one of the examples that I’ve given is… I looked at some of this private credit that was issued in the post-COVID period where rates were really low.

And this attorney’s comment was, you know, we got into this mess because everybody overlooked due diligence and covenants because they just wanted to lend money at higher rates. And there was such a demand that the issuers would go to the lenders and say, “You know, we wanna put this piece together.”  And they [the lenders] would say, “Good, we need two weeks to do due diligence.” And they [the borrowers] would say, “Well, we can get this done tomorrow if you don’t do due diligence without you.”  “Okay, we’re in.”  And now this is what happens. This is what keeps attorneys busy. But what’s going on here is, if you look at one of these loans that was issued, then I did some work a few weeks ago. I had, the numbers are a little outta date because rates have moved, but I looked at just IBM bonds and notes that were issued in 2021 and 2022 when prevailing rates were very low. Well, these were issued at par, sometimes with coupons starting with a zero handle, sometimes coupons starting with a one handle.  And those loans, depending on time to maturity now, are marked between, call it 98 1/2 and 95, or something like that. Now, nothing changed in the credit quality of these notes, right? There was just a change in prevailing interest rates that went from one-ish to four-ish, and that reflected the change in interest rates.

So to me, it’s kind of fictional to say that all these loans that were issued then, are still at par when it’s obvious that they, unless there was a market improvement in their credit quality, which they can’t all have improved their credit quality over that period of time. The stuff that wasn’t, that didn’t have changes in marks, to me, is a bit sketchy.

A bit, you know, it caused… and then when you have things like someone like Blackrock saying, oh yeah, we had this in our portfolio at par and now we’re gonna mark it down almost to zero. That’s telling you that there’s stuff out there. Is it truly a systemic as the financial, global, financial crisis? I’m gonna say probably not, but you know, we could get really ugly without things being that, that bad in the meantime. I’m gonna throw it open to the other guys ’cause I’ve been monopolizing the time here.

Steve Sears

Well, I mean, I remember a very suave strategist today. Very suave, large investment bank asking, you know, potential investors, can you afford to be illiquid? And of course, well, “Yeah, I’m rich enough to be illiquid. Like, what do you have?” And I’m gonna pay you x-hundred bips above, whatever it is. And oftentimes the banks were moving debt off their balance sheets and packaging it. And the debt that was on the balance sheets was from commercial bank clients, not big enough to access capital markets. So, there’s a whole massive ecosystem that exists. You know, in addition, we’ve also seen the rise of private equity in the past decade when rates were as low as they were. So, I imagine that this is simply a growing pain for that industry.  If you went to any financial conference over the past decade in particular, there was always a hall packed with the private equity guys doing their spiel. So, does it become a big issue? I well remember during the financial crisis when the muni market froze.  I mean, there was no liquidity in it.

And so, what happened? ETFs for munis, because who’s the buyer of last resort when the institutions or the ultra-high net worth don’t wanna sell, but no one’s there? It’s John and Jane investor. So, I think that there’s an issue, but I don’t know how to size the magnitude of it. In short, it’s just one of these things we have to work through.  What concerns me to Steve’s point about the due diligence? It’s like, “Due diligence. What’s that? You mean I have to research things?  Things don’t quite go up?” You just don’t know how much garbage is there because, as Steve said, we have these problems on the periphery, but all kinds of horrible stuff happens on the periphery and it tends to multiply like a bad infection.  And I just didn’t know how it was gonna be taken down.

Andrew Wilkinson

I’m still having a hard time with the FOMO argument that this market goes higher. I feel like we’ve become… investors have become so entrenched in this by the dip psychology that with what is essentially a new world order thanks to Donald Trump. I can’t help but think that it’s just being treated as another crisis and, oh, it’ll be gone soon.  Kevin Davitt, if you know, where would you put your money on a new high for the year or a new low for the year. You can say “both.”

Kevin Davitt: Yeah, that, that is my inclination. I am slow and maybe I’ve just had enough coffee this morning to be somewhat glass is half full.  To bring in a 2008 analogy, I do think about incentives and I think about psychology, and sentiment has gotten about as low as it has in many years lately.

And there’s always gonna be someone making the comparison to that awful thing that people already remember. In reality, markets are like a weighing mechanism versus voting long-term, right? I wouldn’t be surprised to see both new lows and potentially new highs this year. This, if there’s something that this year reminds me of, it’s a very similar period from last year where markets fell kind of into end of quarter. There are some unique corollaries to big option positioning that the market moved through last week and back above yesterday into end of quarter positioning. And then last year we had this overhang with liberation tariffs. Now, things are probably not likely to resolve as quickly and the heads up on Twitter or Truth [Social] might be coming from Iran this time. But what is certainly different from our reference to World War I and Truth [Social] is that options are available and broadly being taken up by the investing public, and we are able to express views about sort of specific areas of the distribution. And I think a lot of people are looking to do that.

There has been less attention further out in time. And when I look at something like a VIX one year measure that keeps kind of grinding higher, that gives me a little bit of pause. But if I had to be put on the spot, I would say that realized volatility probably continues to move up closer to what the VIX or VXN Index have been implying, and we get wider ranges in the coming weeks, and ideally some clarity around the Middle East situation. Hopefully this doesn’t drag out for months and months.

Steve Sears

I’ll tell you if I can add one thing here about the upside. Before all this stuff began within six to eight weeks ago, there was huge OTC trading in SPX 8,000, and you had institutions were coming in, and they’re doing these very narrow spreads, like two three point spreads OTC, and then the desks are laying off the risk with wider spreads in listed.

So I, you know, to Kevin’s point, yeah, I suspect, you know, if we can make a move like we did yesterday on a tweet, that the war is over, then really anything is possible.

Andrew Wilkinson

Steve Sosnick, final thoughts.

Steve Sosnick

You know, we’re taping this Wednesday morning. Markets are a bit higher because there was, you know, sort of more back and forth with a positive spin about, you know, potential for peace in the region. You know, the President is going to be speaking tonight, so we’ll learn a bit more, although. To me, two pieces. You know, I think that we were off to a more enthusiastic start before two things happened. Number one, a very sensible piece of news from the President saying, “Oh, by the way, we’re not gonna call this over until the Gulf or this Strait is reopened. That’s good,.  Basically, to me, I was like a little stunned yesterday ’cause the initial reaction was, “Wait a minute, we’re just gonna walk away and leave this a problem?”  That doesn’t solve anything. Now, Iran is basically saying, once again, “No.”  So again, what I would say here is follow the oil markets. Yesterday we didn’t really get a big move down in oil, which is telling me that the oil traders were relatively skeptical. And also watch the shape… If you can, watch the shape of the Brent crude futures, the steepness of the backwardation. And it’s important to realize that looking out a year in the futures markets, which get rid of the initial noise. They’re in steep backwardation, but they’re still pricing in about 15 to $20 higher oil than they were pre-crisis. Which is telling you that there is…

Steve Sears

Because it’s going to take months to clean this up.

Steve Sosnick

Yeah, exactly. It’s a pig in a python problem. And so, we’re not going back to where we were. I do think also yesterday… or if we are going back to where we were, it’s not gonna be immediate. And the other interesting thing is, Kevin, you alluded to this, yesterday was end of the quarter. And I think you had markets with people who do not like trading from the short side. I alluded to that earlier, which is part of my theory about upside skew people are not comfortable. It’s in it’s unnatural to a lot of people. You know, it’s not…

Steve Sears

Puts and calls?

Steve Sosnick

Well, I just mean selling.  I just mean trading Delta from the short side, whether you’re short.  Selling rallies as opposed to buying dips. Buying is natural to people. Markets are supposed to go up. You’ve coined the term, which I’ve done my best to popularize. Yesterday was the perfect example of “Socially Acceptable Volatility.” Okay. And I mean, Thursday, Friday. Those were plain old volatility. They were scary.  Yesterday, we had a bigger move, and everybody was happy because it was Socially Acceptable Volatility. It’s still volatility,

Steve Sears

I think that maybe we should create a Socially Acceptable Volatility index to complement the fear gauge

Steve Sosnick

I think so. I think maybe that’s our next project.

Kevin Davitt

Guys, my argument there would be that the Nasdaq 100, with kind of a 1.2 beta relative to the SPX, what we see when markets are moving higher, is that’s expressed typically without performance. That volatility spread has narrowed as typically happens during some sort of crises. But I love that thinking because it so clearly reflects sort of long-term behavior. And I think we could see it on full display both ways in the coming weeks. Socially Acceptable Volatility. I love it.

Andrew Wilkinson

Brilliant.  That’s an expression I have to add to the Interactive Brokers Campus glossary where you’ll find fantastic terms like “backwardation” that Steve was just talking about. So, I’d love to thank my guest, Steve Sears the Striking Price columnist from Barrons. Thank you, Steve.

Steve Sears

Thank you sir.

Andrew Wilkinson

And Kevin Davitt, head of Index Options Content at the Nasdaq.  Thank you very much, Kevin for joining us today.

Kevin Davitt

Thank you, Andrew.

Andrew Wilkinson

I’m Steve Sosnick, who’s heading outta here, he’s hightailing it to Long Island as soon as he can. Steve, thank you very much for taking the time this morning.

Steve Sosnick

Thank you. And this was a real, this was a real treat. I really enjoyed this discussion. Thank you. Thank you for arranging it, Andrew.

Andrew Wilkinson

And I hope Steve, you don’t come across any pigs in pythons on the way.

Steve Sosnick

I certainly hope not.

Andrew Wilkinson

Alright. Thanks to everybody for taking the time to listen. If you enjoyed today’s podcast, remember, you can subscribe wherever you download your podcasts from. Bye for now.