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Is the Stock Market Exposed To A Short-Term Correction?

Is the Stock Market Exposed To A Short-Term Correction?

Ryan Grace,

Key Talking Points:

  • Equity index and sector volatility risk premiums are trading at monthly lows.
  • Low volatility risk premiums can precede episodic volatility expansions and leave stocks exposed to a short-term selloff.

Following a period of what’s often characterized as “seasonal volatility,” the S&P 500 has recovered its recent 5% drawdown from the past month and is back near an all-time high, while volatility has absolutely collapsed. If you’re bullish, it’s starting to feel good again.

I’ve previously covered the sector and factor signals influencing my bullish view (at least over the next couple of months), and thus far, we seem to be moving in that direction.

So, what do we have to worry about? Well, complacency breeds contempt.

By some measures, there’s a lack of fear in the market, and this has caught my attention. It's not often stocks crash when traders are fully positioned for a selloff, instead it usually happens when most investors least expect it. You don’t see the black swan coming.

Now, I’m not calling for a crash, but there are a few observations worth mentioning that could signal the window is open for a short-lived period of weakness.

Let’s start with the VIX.

The VIX is a real-time volatility index used to measure expectations of risk or future short-term volatility in the S&P 500. The index is calculated from the prices of S&P 500 options. As the prices of these options increase the VIX rises and vice versa.

VIX 1-Year, Daily Chart

Is the Stock Market Exposed To A Short-Term Correction?

The VIX also tends to move in the opposite direction of the stock market. Usually, when stock prices are increasing, traders have a sanguine outlook on the prospects for future returns and therefore are less prone to buy put options to hedge their downside risks. Then, when stock prices correct lower, investors often rush to hedge their positions, typically by purchasing put options. This increased demand for protection drives option prices higher, resulting in a rising VIX as the value of the S&P 500 declines.

We can observe this relationship below.

SPY/VIX 1-Year, Daily Chart

Is the Stock Market Exposed To A Short-Term Correction?

As we can see in the chart, as measured by the VIX, equity implied volatility is at a yearly low. A signal of relatively cheap option prices and a market environment in which many investors are in no rush to hedge potential downside risks. At times, this can act as a contrarian indicator, but on its own, a low VIX doesn’t mean volatility will expand imminently and the market will sell off.

But, when we take it a step further and analyze relative implied volatility risk premiums by comparing 1-month implied vol versus 1-month realized vol, we find there’s little to no volatility risk premium currently being priced into the market across equity indices or sectors.

Said differently, option prices and subsequently implied volatility levels are relatively low compared to how volatile the stock market has actually been over the past month.

S&P500, Nasdaq 100, and Russell 2000 1-Month Volatility Risk Premium

Is the Stock Market Exposed To A Short-Term Correction?

On a 1-month lookback, the market has traded with an annualized volatility of 14% versus a current forward looking implied volatility of 15%, representing a current volatility risk premium of only 10%.

For context, over the last month, the volatility risk premium in the S&P500 reached a level of 140% amidst Evergrande contagion fears and ahead of the pivotal September FOMC meeting.

Digging into this further, monthly volatility risk premiums across equity sectors are also at depressed levels and in some cases are even trading at a discount to realized volatility.

S&P 500 Sector ETF 1-Month Volatility Risk Premium

Is the Stock Market Exposed To A Short-Term Correction?

A signal or noise?

On its own, a low equity volatility risk premium doesn’t mean the market primed to selloff, but it’s certainly worth noting that traders are far from positioned for any near-term market uncertainty. It’s also possible realized volatility levels roll over here, in which implied vol risk premiums would again widen out.

Though, barring a dramatic fall in realized volatility, I read these current levels as a signal; investors are in no rush to protect or hedge positions by purchasing put options. In my view, it’s during these periods of low volatility when markets can get caught off guard and are potentially more susceptible to a risk-off move and short-lived volatility expansion.

On a near-term tactical basis, low volatility risk premiums could present an opportunity to take a bearish position via buying put options or put spreads on an equity index such as the S&P 500, Nasdaq 100, or Russell 2000. I’ve included an example of a possible way to express this view below using a bearish vertical put spread on the Nasdaq 100 ETF, QQQ, within the tastyworks trading platform.

Trade Example: QQQ 377/375 NOV 5 21 Put Spread

Is the Stock Market Exposed To A Short-Term Correction?

Or, instead of tactically positioning for a move, bullish investors could alternatively use this as a signal to wait patiently for lower entry point into a long equity position.

As you can also see above in the chart comparing the relationship between the VIX and the S&P 500, short-term volatility spikes have coincided with decent entry points into the market. Specifically, when the VIX has moved towards the top of its recent range (near 25), this has marked a short-term bottom in the stock market. For context, the VIX is nearly 10 points below this level today.

Given the lack of volatility risk being priced into the options market coupled with the S&P 500 trading near an all-time high, I’m anticipating some expansion of volatility over the next 1-2 weeks.

Should this occur, I’ll likely use it as an opportunity to re-establish long stock positions, given my bullish outlook for the coming 1–2-month period.

Resources for Traders

Whether you are a new or experienced trader, we have several resources available to help you; indicator for tracking trader sentiment, quarterly trading forecasts, analytical and educational webinars held daily, trading guides to help you improve trading performance, and one specifically for those who are new to forex.

---Written by Ryan Grace, Chief Market Strategist at tastytrade

You can follow Ryan on Twitter @tastytradeRyan

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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