Extreme Market Shocks From A Low Volatility Environment (Preview)

By Lawrence G. McMillan

Market shocks can come in a variety of forms. Sometimes the market is wary that a correction might occur. Sometimes it is blissfully unaware of the dangers that lie ahead.

Typically $VIX or other measures of implied volatility are a reasonable measure of the general market’s attitude prior to a market decline. When traders are wary of a correction, $VIX will be high. For example, at the beginning of 2009, even though the market was up 25% or more from its November lows, $VIX was at 40. Hence, traders were plenty leery of the downside risk in that market – and it did occur, as the market plunged to new lows over the next two months.

At other times, though, $VIX is extremely low prior to a market break. This is less common, but it does occur occasionally. Typically, it would be the first breakdown for the market – a warning sign that there is danger ahead – and then $VIX would elevate going forward. The action in July of 2007 illustrates this. $VIX was trading around 15 (very low for those days) and suddenly the market went into a sharp correction as we learned what “subprime debt” was. After that, even though $SPX rallied to new highs in October, 2007, $VIX was much higher as the market reassessed risk. $VIX had been trading in the 13-14 area as late as June 2006, but after the July-August market correction, $VIX traded in a range of 18 to 30 until the market crashed in October, 2008, at which time $VIX exploded.

Last week’s decline was one of those that came from a period of extremely low volatility. $VIX was below 15 and as low as 11 last month. Even though there were warning signs about a market decline – signs which we have been discussing in this newsletter for some time – they did not transfer to a higher $VIX. Then the market broke down sharply last week, losing 7.8% over six days, where most of the damage came in two days (a loss of 6.4% on October 10th and 11th, combined). This action was very similar to what had happened in February 2018, where $SPX collapsed over 7% in a matter of days, from a period where $VIX was extremely low (below 13).

This led us to scrutinize some data. We wanted to know just how rare or frequent it is for the market to have a sharp correction from a period of very low $VIX. Specifically, we phrased the study as: “How many times has the market corrected 6% or more in less than two weeks, where $VIX was below 15 before the correction began?”...

Read the full article, published on 10/19/18, by subscribing to The Option Strategist Newsletter now.