Post-Election Volatility Crush Has Options Traders Chasing Rally
(Bloomberg) -- The forecasts for a drop in stock-market volatility after the US presidential vote have come about even faster than expected, with options traders now positioning for an extended rally.
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The post-election outcome is crystal clear and in strong favor of risk taking, with the only real surprise being the speed of the resolution, which spared days and possibly weeks of uncertainty. With hedging demand shrinking at nearly the fastest pace since the financial crisis and rally-chasing in full swing, volatility has nowhere to go but down.
“One reason for the extended period of implied risk was the potential for results to be delayed and disputed for a long period,” Rocky Fishman, founder of ASYM 500, wrote in a note. “With the presidential results clear, that risk is much reduced, and markets have responded by marking down implied vol across the curve.”
It was widely expected that should the election yield no drama, volatility would fall through year-end, as it normally does. Still, the speed with which the S&P 500 Index surged and the VIX plunged last Wednesday underscores just how much hedging was in place ahead of the event. That day, the equity gauge jumped 2.5% for the biggest gain into a record high since March 2000.
“Over-hedged SPX puts are now deeply out of the money with their implied volatility cratering, while ‘right-tail’ hedge calls slide toward in the money,” noted Nomura’s cross-asset strategist Charlie McElligott, adding that this creates what is known as a “vanna-tailwind.” In that scenario, market makers need to buy more futures to rebalance their books.
The drop in volatility is most pronounced in near-term VIX contracts. The futures curve has reverted to a more normal contango, where further-out contracts are at a premium to those near term. It’s a sign that markets are moving toward the calm levels last seen before the August volatility shock.
“A reduction in hedging signals increased investor confidence, which often leads to higher stock prices as more investors enter the market,” said David Lin, founder and chief executive officer of Linvest21. “But prolonged optimism can inflate stock prices beyond their intrinsic value, raising the risk of a correction.”
Other market measures are also pointing toward a lull.
The so-called volatility of volatility, or VVIX — which falls when there’s less demand for hedging with VIX options — cratered between Tuesday and Thursday, posting the third-fastest rate of decline since before the financial crisis, data compiled by Bloomberg show.
That came after a flurry of investors bet on a year-end rally and drop in volatility in the days before the election. They drove open interest in VIX puts above 5 million contracts, the most since August.
The Nations SkewDex Index, which tracks the premium of puts used to protect against equity selloffs, has fallen to the lowest since mid-August. And the movement goes beyond stocks, with bond and currency volatility also in retreat.
With bearish hedges being lifted, systematic fund buying and investors fully chasing the rally in everything from banks to industrials, there’s little in the way of the short-term rally. But that may also leave less cushion to stem a selloff if there is a shock that sends shares lower.
“Now that the two major market-moving events are out of the way, there is a risk that speculative money pushes ever-risky asset prices to overbought levels,” said Gareth Ryan, managing director at IUR Capital. “Being long the market inherently means an investor is shorting volatility. That can come back to bite.”
The unwinding and expiration of hedges as well as FOMO rally-chasing can be seen in the skew as well, where demand for calls on major indexes, especially small-cap stocks, has surged and puts dwindled. Smaller companies with a more domestic focus are seen doing better under a Trump administration protective of US manufacturing.
The volatility plunge in the US isn’t fully carrying through in Europe, where investors are weighing the potential impact of tariffs. The Euro Stoxx 50 Index gave up early post-election gains on Wednesday, and the VStoxx Index measuring volatility on the benchmark is now holding above its US counterpart VIX, both for spot and the futures curve.
What’s clear is that money is flowing in fast and furious in the US. Some $20 billion was poured into the nation’s equity funds on the day Trump claimed victory, according to Bank of America Corp. That was the most in five months, strategist Michael Hartnett wrote in a note, citing EPFR Global. Nomura sees $110 billion of buying by volatility-controlled funds through January.
But the risk-taking frenzy comes with a little warning, according to Tier 1 Alpha: “It’s important to remember that upside volatility is still volatility, which can have a destabilizing effect on a lot of the systematic strategies that we track.”
--With assistance from Elena Popina and Christian Dass.
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