Updated: Oct 29, 2022
While we've had a rather impressive rally from the October 13th CPI lows, underneath the surface I'm beginning to see some signs that concern me.
Well hedged markets can withstand negative catalysts in a more orderly manner than poorly hedged markets, and in a poorly hedged market you can even see disorderly declines.
Put skew is back to levels we haven't seen since the COVID crash and earlier. This is likely indicative of a poorly hedged market for the following reasons:
There is less skew toward put premium, meaning there is less hedging activity at the index level, where larger institutions like banks and hedge funds try to reduce risk through put exposure.
Because it is likely that there is less net put exposure, that means if there is an aggressive sell-off it would have the likelihood of being more extreme as poorly hedged market participants sell their positions as they don't have their puts as protection to make up for the loss.
As a result, the current market structure, as seen through put skew on the S&P 500, suggests a market that is more vulnerable to significant left tail risk if there is a meaningful catalyst.
At present 1-month realized volatility on the S&P 500 is 28.59, and implied volatility last read at 27.12. That suggests that implied volatility on the equity index is becoming more attractively priced.
The above chart demonstrates that the MOVE index (blue) has been rising markedly since late 2021, while the VIX has not followed. This doesn't imply that the VIX has to move higher, but it does make it more likely. Credit market volatility tends to permeate into equity markets.
The VIX term structure has been improving of late, but as of the last three trading days I think it's been beginning to become cheap vs realized volatility. That also suggests a poorly hedged market.
The chart below from our friends at Tradewell.app shows the S&P 500 index over the last 22 years.The black dots represent periods where implied volatility (VIX) was below 1-month historical volatility by 1-3 (presently 1.93 points below).
We can see that these dots are helpful to illustrate periods of time when tail risk is increasing in both directions, but particularly to the left. One such dot just printed yesterday.
During prior periods where implied volatility was 1-3 points below realized returns over the following 20-days had returns varying from up 14.1% to down 27.72%, or some chance of a fatter left tail.
While the occasions of that larger left tail risk are fewer, they are noteworthy given that the probability for such an occurrence is higher in a poorly hedged illiquid market that is largely driven by options trading at the index level, amplifying leverage and all of this as a result increases volatility.
We are experiencing a market environment where risks are rising, particularly to the downside. That doesn't mean we're setup for a disorderly decline, but it does make one more likely if there is a powerful event catalyst.
Caution is warranted in position sizing and duration of trades during times such as these. Don't forget we have the Fed coming up next week on Wednesday, November 2nd!