Grab Your (Left) Tails

After poking their heads “out of the bunker” beginning early last month, market participants are again demonstrating a propensity to focus on potential downside, which is perhaps not surprising given nosebleed valuations, stretched positioning and renewed virus concerns.

Last week, Goldman’s Rocky Fishman suggested investors should view the decline in implied vol as an opportunity to add hedges.

“The floor in implied volatility that has held since the aftermath of November’s elections was broken by several vol points,” Fishman said, on April 14. “In our view, this is an opportunity to add to short-dated hedges, as we expect a return to 2021’s prevailing high volatility risk premium before long.”

Fast forward several days and, as Nomura’s Charlie McElligott wrote in a Wednesday note, “the big deal this week has been the outperformance of Eq Vol relative to the moves in spot.”

Once again, market participants are concerned about the left-tail, after spending the last six weeks (or so) considering the “risk” of a melt-up. Vols and Skew are “very jumpy,” Charlie remarked, before elaborating a bit on thematic unwinds in pro-cyclical expressions and then delving into what he called “an admittedly ‘voodoo / wonky’ study” aimed at extracting some manner of tactical trading opportunity from richness in tails versus cheapness in implied.

Specifically, McElligott looked at the local high in the VVIX/VIX ratio and found nine events since 2006 when the 12-month rank was > 96%ile, contingent on a VIX 12-month rank < 2.8%ile.

“The message at the very least was ‘chop’ potential ahead for SPX over the upcoming three-month period,” he remarked, noting that the average S&P 500 return three months out was -2.2%. The median was -1.0%.

There was “a substantial max sample drawdown,” where “substantial” means more than 18%, but given the small “n,” I’m not sure that’s anything to panic about, especially considering the anchor date for that was 12/24/2019. Add three months to that date and you’ll discover the reason for the drawdown.

That said, Charlie did emphasize that “the VIX itself backtests to a higher median return at three months, with an average +66.8% and a median +18.1%.