Why Volatility Spiked Higher Than Expected

The first few weeks in April saw stock market volatility reach crisis highs. If you were tracking the Nasdaq 100, it looked as though the market was playing on fast forward. While the main culprit for this was a drastic change in U.S. trade policy, there was another story under the surface exaggerating the price moves: a shift in option flows.

From Cushion to Catapult

Until recently, short-dated options, around 1 day to expiry, were mostly being sold by market participants. These left dealers net long options, or in other words, long gamma, which means they have to hedge in the underlying market by trading against the prevailing trend (buying on dips, selling into rallies). This helped compress the daily range and has been shown to dampen volatility overall.

But then the mood changed.

As trade tensions escalated and uncertainty spiked, traders stopped selling short-dated options and started buying them. That flipped the dealer positioning from net long gamma to net short gamma.

And when dealers are short gamma, they hedge in the opposite direction, essentially they chase the market, i.e. buy when prices go up, and sell when prices go down. So instead of dampening volatility they intensified it.

Negative Gamma Everywhere

Usually when you see short dealer gamma, the feedback loop is localised. You get wild swings around particular strikes but then the market finds support or resistance either side. But this time, negative gamma was spread across the curve, practically every strike and every (near) expiry. The whole surface was suddenly covered in ice.

The result was a violent ricochet in prices, with no obvious stopping point. The price action looked excessive even relative to the newsflow. To many traders it seemed as though the market was overreacting.

The result was the Nasdaq entering a technical bear market, with a peak to valley drawdown of over 25%. This was followed by one of the biggest one day jumps in history when the policy was temporarily halted.

It is also worth noting that even with all these extreme price moves, VIX did not reach the levels seen in previous major crises. Spot VIX peaked at 60 while the futures market was highly backwardated, front month futures hit 41.5 and second month futures peaked at 35. VIX1D however, which is VIX for 1-day-to-maturity options hit 82.5. Which is an indication both that people expected this situation to be resolved quickly, and that people are increasingly hedging event risk with very short dated options.

So, Where Are We Now?

With the worst of the policy panic behind us (hopefully), implied vol is starting to look rich again. That’s tempting some sellers back into the market, mostly selling covered calls, short call spreads, and ratio spreads. These are adding little pockets of positive gamma back into the curve.

That’s helping to restore order.

But this is a delicate equilibrium. With the proliferation of short dated options this experience has taught us that a change in attitude can very easily shatter fragile markets.  If the trade war were to escalate the whole setup could invert again, and markets could once again devolve into crisis.