SPECULATIVE UNWIND KEEPS VIX upside-down
Sept 2020 return comparison. Click for larger image
Continuing the streak of positive correlation that began in mid-August, the VIX and stocks fell together in September, creating a drag from hedging positions that were added early in the month in Smart Index, Smart Tech and Legacy Navigator. Benefitting from its focus on long and short S&P positions, Alpha Seeker notched its 3rd consecutive positive month and has now doubled the S&P 500 on the year with just 0.29 daily correlation.
POSITIVELY INCLINED
Normally, the demand for insurance exceeds the demand for lottery tickets. In finance this shows up in the “skew” of option prices towards put options that normally make them dominant factor in determining the level of the VIX. When demand for options is skewed toward protection (puts), the VIX Index (the demand for put options) rises as the market falls, and vice versa.
Mirroring the persistent skew toward puts after the market crash in 1987, the daily correlation of the VIX Index with the S&P 500 since 1990 is -0.70, a strong but not perfectly inverse relationship. Positive VIX/S&P correlation can occur when option demand shifts strongly toward calls, typically around speculative peaks like the massive one we’ve seen in recent weeks (see chart below).
Small Trader Option Premium vs S&P 500. Source: @SentimentTrader. Click for larger image.
During these periods, the VIX Index can be “upside-down”, driven by the demand for calls (lottery tickets) rather than puts (insurance). As the speculation peaks and demand shifts back towards put options, the VIX/S&P relationship then normalizes. For more information, see Matt’s appearance on a recent podcast as well as his contribution to this Bloomberg article.
Like so many things in markets, this is a naturally cyclical process driven by human emotion. As this cycle plays out, we will continue to be guided by the “Holy Grail” of investing:
