Tags: super | tuesday | volatility | curves

Super Tuesday Hedging Already Showing Up in Volatility Curves

Super Tuesday Hedging Already Showing Up in Volatility Curves
(iStock Photo)

Tuesday, 21 January 2020 11:45 AM EST

Alarm bells are sounding in volatility markets amid a set-up that traders warn has some resemblance to the period preceding the February 2018 risk rout.

The signal is flashing from contracts tied to the VIX, the benchmark gauge for turbulence in U.S. stocks derived from options in the S&P 500. Through those tea leaves, a build-up of trader anxiety is taking shape in the relative cost of near-term versus long-term derivatives. One explanation is the large number of presidential primaries in early March.

A technical indicator, to be sure, but throughout this bull market a reasonably prescient harbinger of turmoil. In fact, most of the selling during major stock drawdowns -- including the fourth quarter of 2018 and the aftermath of the Chinese currency devaluation in 2015 -- happened after an inversion of the VIX futures curve. Normally upward sloping because people are more worried about the future than the present, a VIX curve that points downward can mean anxiety is coalescing around the here-and-now.

The somewhat technical details are these: expiration of January VIX futures is Wednesday, at which time February becomes the front-month contract. If nothing changes, the roll from one contract to the next will result in a flattening in the spread between front and second-month futures. That’s something that warranted investor attention in the past. Currently 2 points, the difference could shrink to less than half a point this week.

The February VIX future has been relatively high in part because of an eventful political calendar. The contract, at expiration, will include options that encompass Super Tuesday on March 3, when a large number of states will conduct primary elections among candidates including Bernie Sanders and Elizabeth Warren.

“This January VIX settlement is looking similar to January 2018 in that the new front month VIX spread between February and March is going to dramatically shrink the level of contango,” said Dave Roberts, independent trader of volatility and volatility products, using the trader term for an upward curve. “Combining this mechanical condition with potential risk-off factors of Sanders winning Iowa and poor earnings reports from the tech heavyweights has the ability to turn a regular pullback in something more meaningful.”

The expiration of the January 2018 VIX futures also eliminated a large degree of contango between the front two months, and was soon followed by a record one-day spike in the VIX Index that forced the closure of several exchange-traded products that let investors bet on enduring market calm.

Unlike 2018, however, this looming dynamic is a function of the soon-to-be front-month contract staying relatively elevated compared to realized volatility in U.S. stocks rather than a case of a tiny premium in the second-month future.

“At present, front-month volatility spreads, quite a large volatility shock would be required to invert the term structure and ignite a cascade of self-reinforcing selling in equity indices,” write Eia Alpha Partners LLC Chief Investment Officer Andrew Middlebrooks and Chief Macro Strategist Naufal Sanuallah. “However, the threshold for inversion will be lower after Tuesday; even a small one-day dip can trigger inversion in the VIX curve.”

‘Potential Unclenching’

A second dynamic in the options market may now be granting U.S. stocks “greater freedom to move in either direction,” according to Nomura Securities strategist Charlie McElligott.

The Jan. 17 option expiry could diminish the extreme “long gamma” positions in S&P 500 options, he said. This refers to a market state in which dealers push against the prevailing market action in order to hedge their exposures, suppressing realized volatility. A “potential unclenching” in the U.S. benchmark equity index may await if these options aren’t rolled, McElligott said.

Even if all the options are rolled, the technical strictures around the market might be loosened nonetheless.

To understand gamma hedging, imagine you’re hosting a party. Making arrangements for six guests who RSVP weeks in advance is easy, and gives enough time to consider what to buy and where. But say hours before the start time, an attendee casually mentions that six friends are coming along -- plus a thunderstorm breaks out. The host must scramble to adjust supplies and shelter for the guests. So too is the case in managing a long gamma position. More hedging is required for any given change in the underlying asset as the expiry gets closer.

The recent passage of options expiration “will make the markets more prone to momentum moves, on the margin,” conclude Middlebrooks and Sanaullah, who believe the odds are rising for a tactical correction in which equities “take a breather” until the second quarter.

Of course, there’s no reason any retreat in stocks has to turn into full-blown mayhem. The exchange-traded products that fueled the turmoil in 2018 no longer exist, and short positioning in VIX futures is well off its November levels. An inversion of the VIX futures curve has plenty of false positives as a timing indicator to reduce equity exposure, too.

On the other hand, the buildup of leverage in strategies that use volatility to determine their market exposures is ascending swiftly, according to Morgan Stanley. That factor, along with stretched equity positioning among trend-following funds known as CTAs, may magnify a run-of-the-mill sell-off into a more material market drawdown.

© Copyright 2025 Bloomberg News. All rights reserved.


InvestingAnalysis
Alarm bells are sounding in volatility markets amid a set-up that traders warn has some resemblance to the period preceding the February 2018 risk rout.
super, tuesday, volatility, curves
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2020-45-21
Tuesday, 21 January 2020 11:45 AM
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