The key concern: an inflation shock that lifts correlations within stock indexes and spurs an extended period of higher volatility.

The spike in oil and natural gas is rippling through supply chains, threatening to raise prices not just for gasoline but for a wide range of goods and services. That’s shifted traders’ attention away from single stocks, as macroeconomic worries begin to outweigh more granular themes such as artificial intelligence. This, in turn, has narrowed the volatility premium for individual shares versus the wider S&P 500 Index and shrunk trading volumes.

Bloomberg

While the VIX has been more sensitive to drops in the S&P 500, the overall realized moves at the index level have remained muted compared with past crises. The volatility gauge hasn’t closed above 30 points this year, after spending two weeks above that level during the tariff turmoil of last April.

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In 2022, the VIX surpassed 30 points periodically following Russia’s invasion of Ukraine and averaged 25.64, more than 6 points above this year’s mean. The S&P 500 fell 19% that year as the Federal Reserve hiked rates multiple times.
“Investors are looking to the 2022 playbook for clues on how the current situation in Iran plays out for markets,” said UBS Group AG derivatives strategist Kieran Diamond. “The risk is an inflation shock, which could drive higher correlations within equity markets, and potentially switch the index volatility regime from fast VIX rises and reversals to one where the VIX floor rises and volatility is sustainably higher.”At the same time, the Cboe Skew Index of market stress has calmed in recent days, possibly because of the unwinding of hedges as investors became disillusioned with vanilla index puts, according to UBS strategists. The low level of realized volatility to the downside since the Middle East escalation may have also caused a general re-pricing of the skew curve.

Bloomberg

While some discretionary traders have leaned into the short volatility trade via VIX put structures, the QIS space hasn’t seen a material shift in investor behavior, according to Michele Cancelli, global head of structuring for the multi-asset group at Citigroup Inc. and global head of QIS trading and structuring.

“Despite the elevated volatility risk premium in SPX, there’s little evidence of a rush into the short volatility trade,” he said. “We’re likely not far enough through the Iran-driven volatility window for investors to have conviction in monetizing it.”

Low realized volatility for the S&P 500 is at odds with the positioning of options dealers. Consensus has emerged among most derivatives strategists that dealers were short gamma heading into the quarterly expiry date. Realized volatility is notably higher intraday versus close-to-close, which may potentially be where dealer gamma is having the greater market impact.

Meanwhile, the broader market micro-structure does not appear to have changed all that much: There’s still significant call overwriting at the index level, as well as one-day-to-expiry condors being sold on an ongoing basis.

Bloomberg

However, the bleeding out of index hedges — whether outright S&P 500 puts or trades like long VIX calls — doesn’t take away the risk-reward from such positions if the market does crack. Furthermore, some investors still see the value in leaning against popular trades such as volatility dispersion.

“We see better opportunities right now from being long index volatility and long intra-index correlation in terms of risk/reward,” said David Elms, head of diversified alternatives at Janus Henderson Group Plc. “Within that space, long correlation via reverse dispersion is interesting given the low levels of implied correlation and the floor to correlation being effectively zero.”

He noted that long convexity is also attractive given the carry cost is lower than historical norms, due to a flow imbalance.

Bloomberg

Another feature of markets has been intraday reversal, highlighting that while option dealers may be short gamma, they are not the key driver of prices in a macro headline-driven environment. The reversals on some level explain muted close-to-close realized volatility — suggesting a cohort of investors are still trading countertrend. On Thursday, the stock market was weak intraday but staged a big rebound into the close.

A flip of such price movement could see reversals giving way to genuine momentum, leading to an acceleration of stock gains as the end of the trading session nears.