One month on from the latest ‘Black Monday’, 5 August, investors might wonder whether the lessons from previous market shocks – such as the surge in volatility seen on 5 February 2018 – have been learned. Fabien Benchetrit provides some answers.
The events that may have led to the 5 August sell-off in developed equity markets have been widely chronicled, notably here.
The August 2024 Black Monday was a particularly dark day for Japanese stocks, with the Nikkei index losing 12.4%, its biggest points drop in a single session.
In the US, while the S&P 500 index fell by 3%, the VIX index, a real-time gauge that represents the market’s expectations for the relative strength of near-term price changes in the S&P 500, soared by 42 points to 65, marking its strongest daily advance since October 2020 (see Exhibit 1).
Why did the VIX ‘fear gauge’ move so sharply?
The cause of large, sudden movements in stocks is often more a combination of factors than a single catalyst, but what was behind the disproportionate spike in the VIX on 5 August?
We believe there are three distinct explanations:
- Fundamental – namely, the events of the previous week (e.g., the Bank of Japan raising its interest rates unexpectedly)
- Internal – namely, the positioning of exchange-traded funds (ETFs)
- Technical – related to the way the VIX is calculated, using S&P 500 put and call options.
The massive rise in the US of options-based ETFs (+600% in three years and attracting USD 115 billion in assets under management has, according to JPMorgan, compressed market volatility and increased leverage and therefore in risk.
Options whose valuations contribute to the calculation of the VIX include highly illiquid instruments (with strike prices that are very ‘out of the money’ (OTM)). These can have a major impact on the index.
In addition, while volumes are principally concentrated on options with short maturities (with zero days to expiry – 0DTEs[1]), the VIX only selects maturities of between 23 and 27 days that are traded less – that makes them less indicative of expected market movements or market sentiment.
A history of quick moves up and down
While the Black Monday stumble looked disproportionate, the speed at which the market ‘normalised’ was also exceptional. Indeed, it took only seven trading sessions for the VIX to return to below its long-term median of 17.6 after breaking above 35. On previous occasions, normalisation had required an average of 170 sessions, apart from February 2018, when it took only 13 sessions.
It is worth remembering that on 5 February 2018, the VIX saw its biggest spike since 1990, both in percentage terms (+53%) and points (+20). It earned events at the time the title ‘volmageddon’.
Years of low interest rates had led investors to engage in large short volatility strategies[2] given the regular returns they were earning from selling volatility using futures contracts. This had driven volatility to an all-time low on 3 November 2017 (9.14). That boosted derivative positions.
Such positioning de facto amplified the shock three months later, on 5 February. Indeed, events in February 2018 resemble those of August 2024 both in the lead-up and normalisation phases.
It’s a classic example of ‘picking up pennies until the steamroller comes along’. It works fine while the steamroller is parked, but not so well when it comes along.
Risk hedging must remain central to investment decisions
Carry trades in 2008 and 2024 – and VIX positioning in 2018 and 2024 – are symptomatic of imbalances and indicative of investors’ excessive optimism and/or complacency.
Human foibles are likely to persist, but the recent episode reminds us that risk hedging must remain at the heart of investment decisions, also when the environment appears favourable. This can be a major challenge because traditional correlations (between, in particular, interest rates and equities) have become unstable, exposures concentrated and leverage levels high.
So, what is the new haven asset? (Hint: it shines[3]).
References
[1] Zero days to expiration options expire and become void the same day that they’re traded. 0DTE options trading has entered the mainstream in recent years and is a popular premium-collection strategy as well as mechanism for high-opportunity speculation. Source: www.investopedia.com/zero-days-to-expiration-0dte-options-and-how-do-they-work-6753832
[2] Option selling strategies – aka ‘short volatility’ strategies – generate returns by earning a premium (i.e., up-front payment) in return for selling options
[3] Also read Geopolitical risk in a multipolar world leads gold price higher (bnpparibas-am.com) and listen to Talking Heads – The case for sovereign debt in multi-asset portfolios – and for gold on our Viewpoint blog
