A Reminder About “Socially Acceptable Volatility”

It’s uncanny – interesting things almost invariably occur in markets when I take a day off.  Yesterday was no exception.  Stocks, particularly those in the tech sector, built off the post-FOMC rally that occurred on Thursday and was modestly reaffirmed on Friday.  They shrugged off the news items that were released after trading for the week closed, including Alphabet’s acknowledgment of its own AI intrusions and Houthi attacks on Riyadh, and instead focused on hopes for peace talks that were reflected in lower bond yields and oil prices.  Once it became clear that stocks were poised to rally, off they went!

As I pored through the data this morning, I noticed that key volatility measures based on the S&P 500 (SPX) and Nasdaq 100 (NDX) rose even as the major indices leapt higher by 1.49% and 2.83%, respectively, in a tech-powered move.  The Cboe Volatility Index (VIX) was up very slightly, rising from 14.81 to 14.87, or 0.41%, while its counterpart, the Cboe NDX Volatility Index (VXN), rose by a more substantial 5.7%, from 19.29 to 20.39.  It was fascinating to note that only 83 more SPX components rose than fell on the day, meaning that the rally, while quite powerful, was less broad-based and more focused than it appeared at first glance. 

The rising levels of VIX and VXN, while modest, received some notice in both financial and social media.  It is indeed unusual to see volatility measures rise alongside major indices, but it is neither difficult to explain, nor is it as anomalous as it may seem.  There are two factors to keep in mind.

First, remember that VIX is not a fear gauge, though it plays one on TV.  That applies to VXN as well.  As we have noted numerous times before, VIX is not specifically designed as a sentiment indicator;  instead it, “measures the level of expected volatility of the S&P 500 Index over the next 30 days that is implied in the bid/ask quotations of SPX options.”  The calculation takes no explicit account of sentiment, though market views on volatility are undoubtedly influenced by direction.  I have likened the role of an options market maker to an umbrella seller.  If we are in a drought, there is little demand for an umbrella’s protection; if clouds appear or the forecast changes, demand increases.  Substitute “rally” for “drought,” and “protective options” for “umbrella”, and you should get the picture.

That points out the second factor: “socially acceptable volatility.”  Yesterday was indeed a volatile day by any measure, but that volatility was in the correct direction.  Hence, there should have been little desire for volatility protection.  But it is important to note that just as sentiment is not a component of the VIX and VXN calculations, those measures also don’t differentiate between upside versus downside options.  Thus, on a day where there are high doses of enthusiasm and FOMO that increase demand for out-of-the-money calls, that demand can push VIX higher as well.  This is particularly true when volatility measures are already flirting with medium- to long-term lows, as is evident in the chart below.

This is the sort of week that can amplify positive sentiment.  There are few external catalysts like economic reports and earnings to influence trading, and while the UN General Assembly and Trump-Xi summits could produce geopolitical hiccups, stock traders have already demonstrated their ability to shrug those off.  As long as the enthusiasm for tech continues and yields cooperate, socially acceptable volatility can lead the way this week.

Source: Interactive Brokers