The Vol Shock Heard 'Round the World

Thoughts on a Historic Series of Days in Markets

Alpha Exchangers, welcome to a special 50 VIX episode of the podcast. As I share some thoughts on these truly historic times, let me just say that for those, like me, that live in the tails of the distribution, it’s like being a kid in a candy store. Market prices are singing out loud, singing proud. Vol is high, vol of vol is high…I’m tempted to say that even vol of vol of vol is high, but I’m not sure that’s a thing.

On a note unrelated to markets, I’m headed to see Glengarry Glen Ross on Broadway this week. I do love me some Kieran Culkin and Bob Odenkirk. It turns out that also in the play is Michael McKean – you may remember him as Chuck McGill from Better Call Saul – or, if you are even remotely close to my age - as Lenny from Laverne and Shirley. “Hello Laverne!”.

I’m also a big fan of Bill Burr and have seen him in concert countless times. His support of Luigi Mangione is getting to be a bit much, I must add. Still, I’m looking forward to this, even if there’s no “AIDA” – attention, interest, decision, action – from someone playing Alec Baldwin. I’ll report back in short order.

“There are decades where nothing happens; and there are weeks where decades happen.” ~ that comes to us not from Vladmir Putin, but from Vladmir Lenin…at least that’s what is suggested. Like Mark Twain, perhaps Lenin is given credit for a few catchy sayings he didn’t actually come up with. But it’s an excellent turn of phrase. To be sure, it’s impossible to argue that nothing has happened in the last decade. Just ask Vladmir Putin himself.

But, you get the point. And it’s difficult to understate how highly consequential these past few days have been. I’m no international trade guru nor do I have any plans to become one. I’ll leave what will amount to ongoing guesswork to those folks and economist types. But I am engaged in the study of market prices and do so with the valuable benefit of having been in a derivatives seat helping large counterparties navigate each of the market stress episodes over the last 3+ decades. With this in mind, I’ve got a few observations on the price action, many of them through the l of derivatives markets and brought to life through my some of my own catch phrases. I’m a simple fellow and keeping track of my house keys and passwords is hard enough. To understand markets, I need aphorisms, adages, and pithy proverbs. So, let’s get into it.

First, I am reminded of my view that “Realized Vol Rules the World”. Consecutive 4% down moves in the SPX are a rare event. Including this past week, there’s only the GFC (twice, in Nov’08) and Covid. Everything in markets is a reaction to realized vol. Option prices respond immediately, as the cost of hedging delta risk balloons when 10-day realized vol on the SPX goes from 17 to 47 in two days. If you don’t trade options, you care anyway about much higher daily swings in prices. Realized vol spikes of this magnitude make your portfolio much larger, increasing your daily value at risk without you lifting a finger. You want the same VaR? You need to get smaller. The process of de-risking – either through hedging or outright selling - reinforces an already fragile environment. The market can’t withstand many more shock days of this magnitude.

The VIX spent a fair amount of time in the 50’s on Monday, April 7^th. You will recall that while it kind of "flash (up) crashed" to the 50's intraday on Aug 5 of last year, that was a fleeting event. This is not. The precedent for a 50 VIX is rather ominous. it's really just the GFC and Covid that got past 50 and both times we were on our way to 80. To be clear, neither of the motivating, destabilizing circumstances that drove those events is in place now. There is no unwind of a massive mortgage credit bubble with huge vulnerabilities resulting from the demise of Lehman and AIG. With respect to the market storm 5 years back, there is no intentional shutdown of the US economy is present now. So, we got that going for us.

I hear all the time on X – that social media platform formerly known as Twitter – that you can’t trade the VIX. Folks get pretty hot on this topic, and I am not entirely sure why. It is true, there’s no security called VIX that you can buy and sell. But you can buy and sell securities that track the VIX with incredibly high precision. And that is, roughly, one month 5% out-of-the-money put vol on the SPX. As I showed on X, these move basically in lockstep. And we know how changes in that implied vol translate to changes in the option price. So, I like to think of the VIX is simply an insurance cost index. If we use 55 as the vol input on a 5% out-of-the-money 1m put on the SPX, we get a cost near 4%.

Now, we all encounter insurance folks in our daily life. Car, homeowner, travel, health, life. You can insure your boat, your pet. Take out an extended warranty on your TV…you get the idea. Most of these feel overpriced. Let's consider the cost of this 5% OTM put on the SPX: you absorb the first 10% of downside. You pay 4% upfront. Oh, and the insurance lasts for a month. Ouch. Financial market insurance is a weird thing. Interest in buying it tends to spike at the wrong time. At some point, the cost of insurance is simply too high, however. And when the overlay hedge ceases to be reasonable, and that promotes further portfolio de-risking.

From a markets standpoint, the higher vol goes, the greater the likelihood that government officials blink in some way. The scars from the market chaos of the GFC and Covid remain. Lutnick's "these tariffs will remain for days and weeks" is far from money good if asset prices plunge and vol spirals higher. You simply wind up creating really hard to fix but also urgent problems when that happens and folks like Bessent know that. I like the quote from Niall Ferguson "the only real law of history is the law of unintended consequences". We live in a pretty interconnected world of international rivalries, debt, trade, asset prices, economies, etc. All kinds of tail probabilities (possibilities at least) become more live when a shock of this magnitude occurs.

I'm in the camp that we are setting up for a nicely tradeable reversal of unsustainably high VIX levels. As always, calling a top is impossible. And I wouldn't outright short VIX futures or calls or SPX vol. but the beauty of VIX options is that you can express a premium contained view on vol going lower through various combinations of puts, 1x2 put spreads, etc.

About Fannie and Freddie, Bill Gross famously said in 2008 as the GFC was heating up, "shake hands with the government and buy what they're buying". There may be a chance to shake hands today and sell what they're selling - the VIX. They won't be able to execute on any policy with the VIX up here for an extended period of time. A 50 VIX is a market moving 3+% every day. That reflects an incredibly unhealthy risk-taking and most likely economic environment.

And that brings me to a second little scribble on my cheat sheet: “Vol Has Memory, Vol Mean Reverts”. We know that vol events tend to cluster. As highlighted, we just got successive 4% down days in the SPX. These episodes of uncertainty also bring big about big up moves. In fact, if you look at history, you will see that the biggest up days in the SPX always occur during the large market shocks. Since 1990, the SPX has had twelve 6% up days, all of which were realized during the GFC and the Pandemic. This is the memory part of vol. When the market is forced to process a sea-change in policy or in its understanding of the state of the world (“subprime is NOT contained”, “a developed market sovereign CAN default”), volatility gathers a dangerous energy. It is this same risk, however, that almost demands policy response from policymakers. Will Trump/Bessent/Powell blink? When the market finds itself short of risk-bearing capital, it is often the case that some combination of monetary policy easing and the provision of public capital/backstop plays a role in arresting the problem, causing vol to mean revert. Some basic “détente” would go a long way towards lower risk premium levels.

I often say that “Risk-on and Risk-off are Curious Cousins”. The mean reversion of vol is nearly guaranteed, even if not easily timed. What was that combination of QE, Fed and Treasury rescue facilities, tax cuts and promises to hold rates at zero that allowed the SPX to bottom in March 2009? It’s difficult to know. With the benefit of hindsight, it’s easy to stitch together the logic that the bottom was in, but in real-time, option prices suggested a more than 50% probability that the SPX could be below 500(!) by the end of 2009 during that March low. However, we should recognize that the history of market dislocations often creates trading opportunities on the long side. When the VIX is at 45, you are getting paid really well to provide insurance capital to the market. Here’s an example: just 2 months ago, the cost of a 2 month, 10% out of the money put on the SPX was 30 basis points. It’s now 7 times that amount, at 210 basis points. So, if you are in the business of collecting such premiums, you raise the same nominal amount and can be 1/7^th the size. That put carries a 38% implied vol and while it certainly can’t compete with the insanity of the Covid crash, it’s higher than anything we’ve seen since the GFC. Remember as well, that policymakers do tend to blink when markets get chaotic enough. You sell vol into these events because you anticipate the (unlimited deep pocketed) government may do so as well. The key is going to be sizing.

Even as we focus on trying to find attractive entry points that are facilitated by some combination of asset price damage and high levels of risk premium, we cannot dismiss that a 50 VIX is a dangerous backdrop. It was Mike O’Rourke of Jones Trading who said, “Broken Markets Break Down”. I really appreciate how efficiently this captures the nature of markets. While a dislocation of this magnitude has historically paved the way to collect risk premiums, we have to respect that things break when market prices move this fast. This is the 9^th 10% drawdown since and including the GFC. At almost 18%, this one is substantial, there’s no way around it. We know that market prices respond first and have predicted 10 of the last 2 recessions, as they say. There are going to be some ongoing sources of feedback. Between asset prices and the real economy (and vice versa), between the Administration and the markets, between the RoW and the Administration, between the Fed and the markets and the Fed and the data (and vice versa).

My own scars from episodes like LTCM, the GFC and Covid are that modern markets mostly, but not always, can self-correct. The old adage, “the cure for lower prices is lower prices”, sometimes does not apply. Markets break. They can topple without backstops. I also point out that the electronification of liquidity provision, an absolute feature of modern markets, is local vol dampening but may leave vulnerabilities to tail outcomes. For example, how did the SPX options market turn so illiquid the way it did on August 5^th, 2024? As we have experienced consecutive enormous daily shocks at the SPX level, what’s the impact on the risk bearing capacity of the system? I’ll note that the CBOE just published a piece in which it found that 47% of all options traded in 2024 had expirations between 0 and 5 days to expiration. These are new instruments in the options market that at least potentially create risk dynamics that we cannot yet fully appreciated.

The ETF space has also seen significant innovation. To be clear, “This is Not Your Father’s ETF Market”. Not even close. NVLD, SMST, NUGT, SOXL, YINN, YANG… These are all leveraged ETFs with daily resetting exposures. They have a simple mandate – deliver 2x and sometimes even 3x – the daily positive or negative return on an underlying index or equity. In the case of MSTU and MSTX, delivering 2x leverage on top of the “Michael Saylor Sound Machine”, MSTR, the feedback with respect to volatility was profound back in Nov’24. The key point on these products is that both the leveraged long and short are amplifiers of volatility in the underlying, sometimes substantially so. Let’s look at the TQQQ and SQQQ (3x leveraged long and short, respectively, on the QQQ) on Friday. Combined, these two saw volume of nearly 500 million(!!) shares. TQQQ – the long version – has seen its AuM fall from 25bln to 14bln since mid February. Market risk changes because the products that populate the market are always evolving. There are no CPDO Squareds to look after right now, but there are daily resetting ETFs. Many of these use derivatives, accessing the leverage through a swap counterparty. For TQQQ, hit up the MHD function and see all of the swaps it uses. When vol gets this high, swap counterparties may decide the carry to be earned for taking the financing risk is no longer a good deal. This gets back to “realized vol rules the world”. Fresh decision-making occurs when vol is restruck so much higher. That can create knock-on effects. The mechanical rebalancing that TQQQ and SQQQ had to do on Friday added nearly 20mln shares to sell in a massively down tape.

Let me continue this discussion with some of my observations on specific asset prices. First, let me say that the phrase “My portfolio is more diversified and more liquid than I thought it was.” is attributable to No One, Ever. It’s always the case that investors find themselves too large and correlated during a meaningful risk off.

Of all the market prices I have seen as unsustainable, it has been the level of realized correlation among stocks in the S&P 500. Incredibly, this measure was 12 for all of 2024. The amount of dampening that this never seen before level has exerted on index volatility is hard to understate. Two things matter here. First, investors respond to what they see and experience via market prices. With correlation so low, portfolio moves of any real magnitude have been few and far between. Take Deep Seek Monday (1/27). NVDA plummeted by 17% but the SPX fell by only 1.5% as AAPL actually rose by 3% that day. Thus, portfolios are sized taking this “offset” into account, with investors banking the diversification benefit as if it will always be there. As recently as mid-Feb 1m realized correlation on the SPX was 2%. Today’s reading: 51%, the highest since late 2022. The same forces – financial, monetary, economic, and geopolitical – that make stocks more volatile also make them more correlated. The 10-day realized correlation between AAPL and NVDA has surged to 81% as their realized vols have spiked to 72 and 73, respectively. True diversification is very difficult to achieve, as we saw in the joint drawdown in stock and bond prices in 2022.

While it, too has started to draw down, gold has been a standout source of diversification. It’s certainly not a hedge you can rely on and gold will buckle as well should the vol experienced so far lead to cascading asset prices, a soaring dollar and a rush to raise cash. I’ve described the 3 different kinds of risk-off, which I call “classic”, “taper” and “liquidation”. The last of these – experienced during a terrifying stretch in March 2020 – is by far the worst and no asset except vol itself can survive. But gold does very well in the classic risk off when stocks and rates fall together as a function of growth concerns. I like to say that you can learn a lot about an asset by simply observing how it does on the worst days for the SPX. When we run gold through this exercise, it shines. There are 39 down 4% or more days in the SPX since 2008. Gold’s average return on those days is +30bps. Its correlation to the SPX on those days is just 22%. It’s unrelated to the SPX when you need it to be (except during a true market liquidation when both the stock and bond market crash together).

Let’s put our vol nerd caps on, shall we, and talk about the SPX Vol Termstructure. This maps the implied vol by expiration and will reliably invert when a shock higher in realized SPX vol occurs. “Backwardations” as some refer to the circumstance when shorter dated implied vol is higher than out months, are rare and fleeting. For example, UX1 (front VIX future) > UX2 (second) only 16% of the days since VIX futures began in 2004. Your longest periods of inversion are going to be Sep-Dec’08; Aug-Nov'11; Feb- May'20 (with one day in contango in there). Termstructure inversions are always related to the level of implied vol as well. It's rare (but not impossible) that a termstructure inverts at a low level of the VIX. The typical sequencing goes as follows: market digests new and unwelcome news, realized vol gets shocked higher (10d SPX realized was 17 three days ago and it is now 47). This causes the most gamma-intensive options to surge in demand because they are most reactive to realized vol spikes. Those are the shortest dated options. Every other part of the termstructure lifts as well, but with declining beta to that realized vol surge.

Next, let’s touch briefly on Inflation and Real Rate Curves. The market is fast repricing both the real and inflation component of nominal yields as well as the curves for each. For example, nominal 2-year yields are down 72bps in 2025, even as break-even inflation is actually up 70bps. This leaves real rates 142bps lower. And the break-even curve has, as it did in 2022, inverted again, with 2’s 108ps north of 10’s in break-evens. By contrast, the real rate curve is upward sloping by 145bps. This is an ugly mix. And it speaks to the real challenges that the Fed will have in executing on the dual mandate set against a backdrop of declining growth but potentially a higher short-term inflation environment. One asset pair that has experienced a pretty disparate relative move over two days is crude, down 13.6%, and one-year break-even inflation which is unchanged. This speaks to the market jointly discounting a decline in growth but firm inflation. In his speech Friday, Powell said that the Fed faces “elevated risks of both higher unemployment and higher inflation.”

And finally, a few observations on how the market prices corporate uncertainty. One of the risk metrics that has proven generally impervious to risk-off episodes (like 8/5 and 12/18 of 2024) has been credit spreads. I published a chart in mid Feb showing that both credit spreads and credit implied volatility were mired jointly in 0th percentiles. The idea was that credit hedges really stood out from a value standpoint and that should the market start to price "real economy" risk with just incremental probability, these would work. That's exactly what has happened with both metrics now in 90+ percentiles. There’s a great index calculated by Bloomberg called Global Trade Policy Uncertainty – ticker BBUNTPGD – which explains why credit is now enveloped in this risk-off. The degree of global trade uncertainty is literally off-the charts. Today’s level makes the trade “war” of 2018-2019 look like a shouting match at best. While we have seen a large move in credit spreads in a short period of time, history tells us that further concerns around growth leave more room for spreads to widen from here. Stepping back, the VIX has spiked more on a relative basis than credit spreads have, but that’s mostly a function of the giant successive moves lower in the SPX and how that impacts a short-dated option price measure like the VIX. If we compare the CDX IG to 1 year SPX implied volatility (22.7), it’s much closer to the historical relationship.