- The CBOE Volatility Index — or VIX, Wall Street's so-called fear gauge — shows that options traders expect the stock market to be anything but calm shortly after the elections.
- Their anxiety has caused a kink known as backwardation in the normal pricing structure of VIX futures contracts.
- They are also pricing in a longer return to normalcy, in contrast to their expectations prior to the 2016 elections.
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After the 2016 elections, investors' worst fears about the stock market's response to the result materialized for all but a few hours.
President Donald Trump's stunning victory on that Tuesday night plunged S&P 500 and Nasdaq futures so hard that limit-down restraints kicked in.
But a swift recovery the following day took the Dow Jones Industrial Average to a new closing high. It was almost like there was no overnight panic in the market.
This time, however, investors could experience a more prolonged and intensified stretch of downside volatility — one that may extend losses incurred during the market's worst week since March. For proof, look no further than the CBOE Volatility Index, or VIX, which tracks traders' expectations for future volatility based on S&P 500 options. The prices of VIX futures contracts are showing that traders are pricing in a wild ride shortly after the elections.
Under normal circumstances, VIX futures contracts get pricier the further out into the future they go, and this produces an upward-sloping line on a chart. In other words, traders usually expect volatility to increase with time.
But the VIX futures curve recently bucked this trend is now downward-sloping, entering what is known as backwardation. That's because traders expect a heightened period of volatility in November, followed by calmer times in December and early 2021.
"The November expiration currently has the highest volatility priced in and then there is a mild drop," said Shankar Narayanan, the head of research at Quantitative Brokers, in a recent note that included the above chart.
He added, "It seems like some market participants are expecting the equity markets to rise after the elections. However, the options term structure is also pricing a longer road to normalcy. We will have better color in a week or so."
Another way to understand what the VIX is signifying is by comparing it to historical volatility. In a note on Friday, BNP Paribas derivatives strategists shared that the gap between S&P 500 one-month implied volatility and 20-day realized volatility was near a decade high.
The spread was also in the ballpark of its location prior to the 2016 election. That said, what makes this year different? Allow Narayanan to explain:
"In contrast to this, during October 2016, the term structure was in contango and there was a higher variation in the levels of the near vs. far contracts. While not shown, there was also more liquidity in the VIX futures prior during the October 2016 compared to now. This could be on account of several reasons including the current market conditions."
In essence, a liquidity-strapped market is hurtling towards a period of political uncertainty with no definitive timeline. And if last week's market action was any guide, investors may continue to fret over record levels of daily coronavirus infections in the US and soaring cases in Europe.
During last week's sell-off, the VIX rose above 40, its highest level since mid-June; it tends to move in the opposite direction to the S&P 500. The economist David Rosenberg and BTIG strategist Julian Emanuel, among others, have conducted studies showing that the index at 40 and above has been associated with equity losses since its inception in 1990.
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