Q: The recent drop in the stock market makes me very nervous. I read that it was caused by a spike in stock market volatility. How does higher volatility cause stock prices to fall?
A: There are two main kinds of volatility and unfortunately the financial press doesn’t always distinguish between them very well. First, there is price volatility. This kind of volatility reflects the magnitude of daily changes in actual stock prices.
Second, there is implied volatility. Implied volatility is a key component of option pricing. As its name indicates, this kind of volatility is implied by the price of the option. The financial press often mentions the VIX index when it talks about volatility. VIX is short for the CBOE Volatility Index and measures the implied volatility of S&P 500 stock index options traded on the CBOE.
The two volatilities are related. In well-behaved markets, if implied volatility gets too far away from actual volatility, traders can arbitrage the difference and make a near-riskless profit. However, if the options market comes under stress causing implied volatilities to spike, the stress can spill over into actual stock price volatility and cause downward pressure on stock prices. This may be what happened with the recent volatility spike.
The volatility spike caught a lot of people by surprise. One of the big money-making trades on Wall Street since 2015 has been to sell volatility. The markets were placid and traders were sanguine. As recently as early January, the VIX traded below 9 percent. However, in late January the market started to decline slightly and implied volatility started to tick up.
Last Friday, the stock market suffered its largest daily drop in more than two years and volatility surged. Global markets followed suit over the weekend and by Monday the U.S. stock market was in full retreat. At one point on Monday, the Dow Jones Industrial Average dropped more than 6 percent inside of 6 minutes. On Tuesday morning, the VIX spiked to over 50 percent.
Nobody is quite sure exactly what caused the market crunch and the volatility spike, but some of the key protagonists in this drama seem to be a group of hedge funds and exchange-traded funds that had large short volatility positions. Once volatility started rising, these funds were forced to cover their short volatility positions. A hedge fund in London called Option Solutions, reported that it lost 65% when it was forced to liquidate its holdings overnight. The resulting activity put tremendous pressure on stocks which further exacerbated volatility and kicked off a self-reinforcing spiral.
These kinds of market corrections are normal and healthy. They bring discipline and help keep Wall Street hubris in check. As Options Solutions found out, hubris can be costly.
It is important to put this correction in perspective. From the S&P 500’s peak on January 26 to its intra-day low on February 6, the index fell about 9.75 percent. From its year-end close to the February 6 intra-day low, the market was down only 3 percent. Those are moves that should be well within expectations for normal market behavior.
You are certain to encounter challenging markets over the course of your investing career. As you do, try to keep perspective on the magnitude of any correction you face. Do all you can to understand what is happening as corrections unfold. Above all, make sure you are invested in high quality investments and proven portfolio strategies that will allow you to ride through market corrections with confidence.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to email@example.com.