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Volatility: What Role Did it Play in the Sell-off

Traders Magazine Online News, February 22, 2018

Luke Oliver

In the past few days, investors have seen something that they haven’t been accustomed to in a while; a broad market slump. It began on Friday, but the selling pressure picked up steam on Monday (February 5th) as the S&P 500 Index closed down 4.10% for the day.

After the close, futures continued to fall into the following Asian trading day, extending the sell-off to 8%. However, from around midnight Eastern onwards in Tuesday, futures recovered to post a 5.40% loss on the session. The Nikkei 225 closed down 4.73%, Eurostoxx 50 was down 2.41%, the FTSE was down 2.64% and U.S. Futures were down 1.3% in the full Tuesday session.

(Source: Bloomberg, as of 2/6/18)

But while these numbers served as a rude awakening to many investors, the real focus was arguably the incredible spike in volatility.

‘Fear Index’ In Focus

VIX, a measure of volatility or risk, jumped to 37.32 from 17.31 on Monday, one of the largest moves ever. This was the highest closing volatility since August 2015, and the volatility spike is possibly the key to this story and will no doubt be an important topic of discussion for investors in the future (Source: Bloomberg, as of 2/6/18).

But what’s behind this huge increase in volatility and why is it such an in-focus topic right now?

Most generally understand that equity price movements and volatility are connected and a down market means an increase in volatility. We also generally believe the stock market is what drives volatility. However, it appears in this case, volatility itself has driven the market lower.

This recent market move was a trading event and not based on fundamentals. This is partially due to how volatility-linked products are constructed and the nature of the derivative market. In short, in any chain of derivatives (things that derive their price from other assets), a market in one has the potential to affect the other. There are going to be a lot of stories on this subject over the coming days, but here is what you need to know to understand it.

What Happened?

On February 5th (Monday), the buying of volatility caused the market to move lower. This can happen when people who were long stocks and were concerned about a draw down act to purchase insurance in the form of options. Investors of all types bought this protection, and as such, there was a natural premium to be made by the parties willing to insure portfolios and take on the risk, the option sellers. This makes sense.

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