Is the stock market exposed to a short-term correction?

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Key talking points:

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

After a period of what is often characterized as “seasonal volatility,” the S&P 500 has recovered from its recent 5% pullback from last month and is back near an all-time high, as volatility has completely collapsed . If you are optimistic it will start to feel good again.

I have already covered sector and factor signals influencing my bullish outlook (at least over the next couple of months), and so far we seem to be heading in that direction.

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

In some ways there is a lack of fear in the market, and it caught my eye. It’s not often that stocks crash when traders are fully positioned for a sell off, but 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 might signal that the window is open for a short period of weakness.

Let’s start with the VIX.

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

VIX 1 year, daily chart

The VIX also tends to move against the stock market. Usually, when stock prices rise, traders have an optimistic view of the prospects for future returns and are therefore less inclined to buy puts options to hedge their downside risks. Then, when stock prices correct lower, investors often rush to hedge their positions, usually by buying puts. This increased demand for protection drives up option prices, causing the VIX to rise as the value of the S&P 500 falls.

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 from the chart, as measured by the VIX, implied volatility in stocks is at its lowest year-on-year. A relatively cheap option price signal and a market environment in which many investors are in no rush to hedge potential downside risks. Sometimes this can act as a contrarian indicator, but on its own, a low VIX does not mean that volatility will rise imminently and the market will sell off.

But, when we go further and analyze the relative implied volatility risk premiums by comparing the 1-month implied volatility versus the 1-month realized volatility, we find that there is little or no risk premium of volatility currently valued in the market through stock indices or sectors. .

In other words, the option prices and subsequently the levels of implied volatility are relatively low compared to the actual volatility of the stock market over the past month.

1-month volatility risk premium S & P500, Nasdaq 100 and Russell 2000

Is the stock market exposed to a short-term correction?

On a one-month retrospective analysis, the market traded with an annualized volatility of 14% against a current forward-looking implied volatility of 15%, which represents a current volatility risk premium of only 10%.

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

Digging deeper, monthly volatility risk premiums across all equity sectors are also at depressed levels and in some cases even trade 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 a noise?

By itself, a low equity volatility risk premium doesn’t mean the market is ready to sell, but it’s certainly worth noting that traders are far from positioned for short-term market uncertainty. It is also possible that the realized volatility levels will reoccur here, in which the implied theft risk premiums would widen again.

However, unless there is a dramatic drop in volatility realized, I am reading these current levels as a signal; investors are in no rush to protect or hedge their positions by buying put options. In my opinion, it is during these periods of low volatility that markets can be caught off guard and are potentially more susceptible to a movement of risk aversion and short-lived volatility expansion.

On a short-term tactical basis, low volatility risk premia could present an opportunity to take a bearish position by buying put options or put spreads on a stock index such as the S&P 500, the Nasdaq 100 or the Russell 2000. I have included an example of one possible way to express this view below using a bearish vertical sell spread on the Nasdaq 100 ETF, QQQ, within the Tasty Trading Platform.

Sample transaction: QQQ 377/375 NOV 5 21 Put Spread

Is the stock market exposed to a short-term correction?

Or, instead of tactically positioning themselves for a move, bullish investors could also use this as a signal to patiently wait for a lower entry point in a long position in stocks.

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

Considering the lack of volatility risk in the options market and the fact that the S&P 500 is trading near an all-time high, I expect some volatility expansion over the next 1-2 weeks.

If that happens, I will probably take the opportunity to reestablish long positions in equities, given my bullish outlook for the next 1-2 months.

Resources for traders

Whether you are a beginner or an experienced trader, we have several resources available to help you; tracking indicator sentiment of the trader, quarterly business forecast, analytical and educational webinars held daily, trade 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 savoureuxtrade

You can follow Ryan on Twitter @tastytradeRyan

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