Over the course of the last few trading days, the market has turned sharply risk off. A busy calendar of macroeconomic data last week jump-started the sharp change in tone regarding risk assets. On the macroeconomic side, weaker-than-anticipated manufacturing data was the first shoe to drop. Later in the week, a weaker-than-expected nonfarm payroll report led investors to rethink the soft landing narrative that had led to strong momentum for risk assets all year. As of August 5, the market is pricing the Federal Reserve to cut interest rates 4.5 times by the end of the year, compared to 2.6 cuts just a week earlier.1 In the three trading days since the Institute for Supply Management (ISM) Manufacturing Purchasing Managers’ Index miss on August 1, the S&P 500 Index (SPX) has traded down 4.7%, while the 10-year Treasury rate has decreased by 19 basis points (bps).2
The volatility market has not missed out on the fireworks. Throughout 2024, implied volatility on the SPX has remained very low compared to history. This has mostly been due to low realized volatility on the index. On the strength of the soft landing narrative, the equity market demonstrated strong momentum, continuing to grind higher all year. The Chicago Board Options Exchange Volatility Index (VIX) — a measure of the implied volatility on 1-month SPX options — has averaged 14.17 in 2024, compared to its 5-year average of 21.18.3 On August 5, the VIX briefly reached 65 and closed at 38.51.4
Another way of gauging the equity market through a volatility lens is to examine the skew present in the implied volatility surface. Skew is a measure of the difference in volatility being charged between an out of the money option and an at the money option. Typically, out of the money puts trade at a higher volatility than at the money options. The reason for this is twofold. Demand for hedges tends to create natural buyers of out of the money puts, which drives up the price of these options. Out of the money puts are also protection against sharp selloffs in the market, where volatility tends to be higher than in more calm environments. This dynamic raises the amount of volatility that is priced in when trading these out of the money puts.
Today’s Chart of the Week shows the 1-month put skew for SPX options throughout 2024. For the most part, it has been very flat. So far in 2024, out of the money puts have traded an average of 1.67 points higher than the at the money in implied volatility terms. This compares to a 5-year average of 3.81 points. This flat downside skew speaks to the complacency seen from investors as the market continued to move upward this year. Flat skew is a result of either little demand for options to hedge downside risks, or the willingness of investors to sell these options and depress the implied volatility. However, over the last three trading days, we have seen put skew take an elevator ride up. The implied volatility for short dated out of the money puts has quickly exploded as investors have reached for protection in the recent risk-off move.
Key Takeaway
Throughout 2024, the SPX options market exhibited calmness alongside its underlying index. For the most part, downside protection has been offered at cheap levels relative to where it typically trades historically. Over the last few days, we have been reminded that risk-off moves happen quickly and can come from seemingly out of nowhere. When the market offers up cheap protection, especially in highly convex instruments like options, it may benefit greatly to utilize them.
Sources:
1-4Bloomberg
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