Three Reasons the VIX Should Collapse This Week

Last week was a week of many divergences and deteriorating correlations that investors usually use to orient themselves sent mixed signals. Volatility for fixed income was incredibly high as Treasury markets reacted adversely to a hot inflation report. Nonetheless, Punk Rock Traders think the preponderance of the divergences, when considered in unison, clearly point to an imminent collapse in volatility.

When these correlations are unstable like they have been in the last few months, Punk Rock Traders springs into action. We laugh at those who refer to volatility pejoratively. We seek it, we do not avoid it. And since the divergences in correlations cause confusion, they also present an opportunity for alpha if you can be more oriented than the competition. There are three major reasons why we think volatility should collapse in the coming week.

Given the extreme spike in volatility during the beginning of August, most asset classes are below volatility extremes for the 52-week time period. All of that except for oil, which we told you to short last Friday. That trade is working out very well. But nonetheless, the natural question when volatility is in the midranges of so many assets, where will it resolve with the S&P 500 making new highs regularly? When you look at certain datapoints, it becomes clear to us at Punk Rock Traders that, absent an unanticipated exogenous risk, volatility should collapse in the coming week.

Firstly, when we look at divergences, a good place to always start in my experience is the credit markets. Many investors forget that equity is junior in the capital structure to credit. It’s important to remember that stocks are a claim on future earnings, whereas credit risk is concerned with the current (and future) ability of creditors to service their debts. Thus, credit can often send a preliminary warnings signal for stocks, especially when it abruptly deteriorates. However, the opposite is also true. Often, when credit sends the all-clear, as you can see it is doing above, the market tends to resolve favorably when volatility is elevated.

Secondly, realized volatility has been very much higher than implied volatility in the past few months. This is typically a rare occurrence and one of the most recurring trades we do at Punk Rock Traders is based on the variance premium; or that implied volatility tends to exceed realized volatility. Since the VIX is mean reverting, I think it is reasonable to assume that the reverse (and more common condition) of implied volatility exceeding realized volatility will prevail.??

The uncertainty associated with the election tends to be overdone and it tends to be followed with an implied volatility crush once the event passes. Even in cases where the outcome was uncertain or took a while to find out, like last Presidential cycle, this dynamic has pervaded. And the VIX remains very much inverted despite positive resolutions on several items. Oil is collapsing today, signaling that the market’s worry about a conflict-driven supply disruption was overdone. Even if Israel attacked Iranian facilities, global output would likely quickly pick up the slack. Oil and credit markets both point to a collapse in implied volatility.

Thirdly, the contracts closest to the election will stop being inputs in the VIX calculation tomorrow when the next batch of VIX options expires. These have likely contributed to keeping the VIX pinned higher. This will likely enable a meltdown of the VIX, particularly since geopolitical risk seems to have diminished. At least that is what the oil market is signaling. I’m also encouraged by the fact that VVIX has been declining over the past five days. The VVIX uses the same essential calculation as the volatility index does on SPX OTM options but does so on OTM VIX options. This is colloquially known as the VIX of the VIX. And it is sending a positive signal.

In conclusion, a lot of the VIX trades we recommended to get you short going into November and December should really take off this week and into the favorable seasonal environment we are now entering. While October is typically a volatile month, it also tends to finish positive and in the 33 year history of the VIX, it has started the month higher and ended it lower 18/33 times. I would also consider it very favorable that the VIX has broken into the $19 handle. We have positioned our subscribers well for the expected collapse in volatility over the next week and beyond.