What the VIX Tells Us About Erratic Markets
The U.S. financial markets have been on a wild ride over the past month. Many experts were surprised by the sudden volatility in the middle of summer, when calm usually reigns. While some see the ominous signs of a long-term market correction, others believe this was a temporary event exacerbated by news out of China (read our blog “China’s Devaluation and Skidding Stock Markets”). The Standard & Poor’s 500 Index (SPX) saw a wild week of trading in late August, when stocks plunged 3.9 percent on the 24th and rose 3.9 percent two days later. This erratic activity was captured by an index called the Chicago Board Options Exchange Volatility Index, or VIX, which showed a particularly high level of risk taking that week.
Two big-picture events triggered the massive selloff on August 24. The first was China’s economic weakness, highlighted by missed factory output and investment forecasts, and the devaluation of its currency. The larger emerging markets (EM) slowdown, a negative factor over the course of 2015, had been hitting the markets hard. The second factor, related to the first, was the weakness in commodity prices, especially oil. Amid softening demand and robust supply, oil prices have fallen this summer and hopes for a near-term reversal look bleak. The sudden bearish tone in the markets was unexpected amid strong U.S. economic data, including declining unemployment, and a benign inflation outlook.
Nevertheless, how these news items were translated into market volatility can be traced by the dynamics of the VIX. One might say that the VIX gauges the current anxiety level of the market, measured as a component of option prices. As the options are bid higher, volatility becomes a larger component of the price. The VIX rises when put option buying increases and falls when call buying increases.During the week of August 24, the VIX was at its highest, a level that had not been seen since the financial crisis (see VIX Futures chart). According to Tracy Alloway inBloombergBusiness, the volatility was largely driven by buyside players dabbling in techniques such as volatility overlays, dynamic hedging and risk parity to boost returns in a low-interest-rate environment. In many cases this involved hedge funds and commodity trading advisors rushing to purchase protection for hedging their short positions.
As a result, the Dow Jones Industrial Average seesawed and moved 10,000 points in merely five trading sessions. VIX futures contracts jumped from negative 53 million to 16 million in just one week, another spectacular illustration of the instability. “Driven by a combination of tactical and structural forces, it is indicative of an ongoing shift in markets’ operating environment”—that’s how Mohamed El-Erian, chief economic advisor at Allianz, put it in a Financial Times blog.
The tense trading also may be influencing the interest rate discussions taking place at the Federal Reserve. Many observers had expected the Fed to move at its September meeting but market gyrations may have given it reason to rethink its timing. While it is hard to say whether recent events are a harbinger of a more serious market correction, the new participants and their strategies could bring structural change.