Let's Take The Pulse Of Volatility As Geopolitical Risk Rears Its Ugly Head

Summary

• Here's a quick check of the volatility landscape as markets digest the latest geopolitical turmoil emanating from North Korea.
• I've updated the Nasdaq versus S&P implied volatility chart and included a few visuals and a bit of color from Goldman.
• Here's hoping everyone remains calm when traders return to the desks after the holiday.

Given the rather (how should I put this?) "unfortunate" headlines emanating from the Korean peninsula on July 4, it's probably worth penning a quick update on volatility, because as Goldman was kind enough to point out in a note dated Monday, "breaking out of a low volatility regime usually requires a large shock, for example a war."

While I won't endeavor to opine on the likelihood of an armed conflict (at least not in these pages), I will weigh in briefly on where things stand in terms of the market's "fear" gauges.

Late last week, I flagged a six standard deviation event in Nasdaq implied volatility, and, in a testament to how you simply can't please everyone, a few readers suggested it was hyperbolic to call that six standard deviation event a "black swan."

Well during Monday's shortened session, the disparity between NDX implied volatility and the VIX became even more pronounced, which isn't surprising given the fact that the Nasdaq (QQQ) was the only one of the big three benchmarks to close red. Have a look at the updated set of charts:

Now invariably, there will be someone who will find something to complain about with those visuals, but the bottom line is that the ratio between NDX implied volatility and S&P implied volatility is at or very near its highest level since 2002.

Remember why that's a problem? Tech has become embedded in a whole bunch of factor-based strategies and some of the low volatility products that recently rebalanced are now sitting on their highest tech exposure on record, positions they can't get out of for at least two months - specifically, the $14 billion PowerShares S&P 500 Low Volatility Portfolio ETF (SPLV) and the $6.9 billion iShares Edge MSCI Minimum Volatility USA ETF (USMV).

More generally, tech has of course exhibited quite a bit of leadership this year, so when you see this kind of reversal of fortunes, you have to wonder what sector will step in and take the baton (maybe financials?).

Meanwhile, it's worth noting that the VIX call/put ratio has spiked to one of its highest levels since the crisis:

(Goldman)

Does that usually presage an imminent volatility spike? Fortunately, the answer to that question is "no." Here's the scatterplot:

(Goldman)

Still, there are signs of growing market angst. "Investors have recently started to position for higher volatility – the open interest in VIX calls has increased, inflows into the largest long VIX ETP (VXX) have picked up and the net short on VIX futures has decreased," Goldman goes on to write, in the same note cited above (more here).

Overnight (so during the July 4 overseas session), the fallout from the latest bout of geopolitical turmoil was relatively limited. But that's largely because everyone is in wait-and-see mode and at least partially because of thin volumes.

It'll be interesting to observe the price action once everyone gets back to the desks after the US holiday.

Anyway, that's the quick and dirty on the "lay of the land" (so to speak) in volatility.

Here's hoping (for your sake, that is) that we "mean revert" to what we're all used to: a volatility seller's/carry trader's paradise.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.