The Options Market Predicts Where Stocks Are Headed After a Wild Week

As the week drew to a close, many investors turned to the options market for hints about the future direction of stocks. One key indicator that caught their attention was the Cboe Volatility Index (VIX), often referred to as the "fear gauge." This index, which measures expected market volatility, had its largest intraday swing ever on Monday, briefly surpassing 65, according to FactSet data. However, by Friday, the VIX had retraced much of this spike, settling around 20, just slightly above its long-term average of 19.5.

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The VIX is a well-known measure of investor hedging activity within the options market, reflecting trading in S&P 500 options set to expire within a month. The sharp rise in the VIX earlier in the week suggested that investors were actively seeking protection against potential market declines. Some strategists, including those at BNP Paribas, interpreted this dramatic increase as an indication that stocks may have overreacted to a few disappointing economic and labor market reports in the U.S.

The market turbulence seemed to be more related to the unwinding of crowded positions in derivatives markets, as well as the yen carry trade, rather than any significant shift in economic fundamentals. Surges in the VIX of this magnitude have typically coincided with major crises, such as the 2008 financial meltdown or the COVID-19 market crash in March 2020.

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Despite the week's volatility, there could be a silver lining. High-velocity market crashes like the one seen tend to recover more quickly than those driven by deeper, fundamental economic issues, such as a slowing economy, which can take longer to resolve.

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During the market's decline, the VIX's increase far outpaced the S&P 500's drop of over 3%. According to the BNP Paribas team, the VIX beta, which measures the degree of the VIX's outsize movement, surged to its highest level since 2022 on a rolling one-month basis. Analysts noted that Monday's VIX spike was one of the most aggressive seen relative to the S&P 500's decline.

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The BNP team suggested that the market downturn may have been exaggerated based on the news flow. They characterized the correction as more akin to events like "Volmageddon" or "Black Monday" rather than a recession-driven selloff.

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A contributing factor to this volatility was the role of option-selling funds. In recent years, exchange-traded funds (ETFs) and other investment vehicles that engage in buying and selling options have become increasingly popular. These funds typically sell options backed by their stock holdings, which allows them to collect premiums in exchange for capping their potential upside while providing some downside protection.

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Options traders pay an upfront premium to purchase an options contract. By selling these contracts, funds can use the premiums they collect to enhance their returns. However, Wall Street strategists, such as Nomura's Charlie McElligott, have long warned that the option-selling strategies employed by these funds have contributed to suppressed volatility, setting the stage for a potentially sharp correction.

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This predicted correction seemed to manifest on Monday. McElligott explained that many sophisticated traders, who use leverage to amplify their returns—whether through the yen carry trade or short volatility or momentum-driven strategies—rely on the VIX and other volatility measures as key inputs to their risk models. Lower implied volatility signals them to increase their leverage. As McElligott puts it, "volatility is the exposure toggle," meaning that a low VIX can encourage traders to take on more risk.

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As stocks declined, options dealers, scrambling to hedge their exposure, may have inadvertently amplified the market's drop. However, as traders begin to re-establish bullish positions in hopes of capitalizing on a rebound, these same options dealers could potentially return to playing a stabilizing role in the markets, according to the BNP team.

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By Friday, the S&P 500 had erased nearly all of its earlier losses, though it still recorded its fourth consecutive week in the red. The Nasdaq Composite also fell for a fourth straight week, while the Dow Jones Industrial Average posted its second consecutive weekly decline.

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In summary, while the week’s market turbulence may have rattled some investors, it also provided important insights into the dynamics of the options market and the role of volatility in shaping market behavior. As the dust settles, market participants will continue to closely monitor these indicators for further clues about the direction of stocks in the coming weeks.

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