After an outsized rally in June and early July, when the market recovered all of its May losses and chronicled fresh highs, stocks have settled into a more complacent mode it appears. The VIX, often an indicator of investor sentiment, has settled around 15, dropping briefly just under 12 over the holiday week last week. But sometimes the quiet leads to a storm of activity unexpectedly.
The Volatility Index, or VIX, an instrument created by the Chicago Board Options Exchange (CBOE), is a real-time market index that represents the market’s expectation of a month period of forward-looking volatility. In most cases, the higher the volatility, the riskier the security. Derived from the price inputs of the S&P 500 index options, the VIX provides a measure of market risk and investors’ sentiments. It is also known by other names like “Fear Gauge” or “Fear Index,” as investors, research analysts and portfolio managers generally look at VIX values as a way to measure market risk, fear and stress before they take investment decisions.
One explanation for the surprise moves in the market is that institutional investors like pension funds are more and more drawn to low-volatility strategies, those using options markets to avert severe losses and deliver more consistent stable income. Yet, whenever they buy or sell an option, their brokers have to hedge their positions by trading in the opposite direction, and market players said the amount of such hedging has now become so significant that it tends to muffle stock market volatility until it suddenly doesn’t.
“All these strategies exist now where pension funds and big funds just want to sell down-side puts.They are constantly selling puts, meaning the dealers are buying the puts and they are also buying the stocks,” said Dan Nathan, principal at Risk Reversal Advisors.
“They know there is a high probability of a small gain and a low probability of a big loss, so this has become a strategy that they are just willing to do — selling downside puts,” Nathan said.
Gamma, the rate of change in an option’s delta per 1-point move in the underlying asset’s price, is an essentially a measure of an option price’s acceleration.
While this can be positive for the upside, the problem is that traders can occasionally become enmesshed in a gamma trap when the hedging exacerbates losses as stocks drop dramatically.
“We have seen this play out many times,” Jon Najarian, co-founder of Najarian Family Partners, told CNBC. “When the market responds to positive or negative news and makes an outsized move, those that sold those calls or puts have to chase prices higher as they try to mitigate losses.”
This gamma effect tends to explain some of the more sudden and volatile moves the market makes at the end of a session or during news events, according to experts.
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