Volatility returns to the U.S. stock market

Stocks suffered their worst one-day reversal since June 2016 on a points basis on Tuesday. First, the Dow Jones Industrials average zoomed past the 26,000 threshold, bagging the quickest-ever 1,000 point gain from its last round number (hit just seven days ago).  

But with options traders increasingly "over their toes" -- positioned too aggressively -- and a combination of cryptocurrency carnage, a push higher in the CBOE Volatility Index (VIX) and fears of a possible government shutdown later this week brought out the sellers. The day ended in the worst percentage reversal since Dec. 1. 

Other negative catalysts on the horizon include the start of fourth-quarter 2017 earnings reports and the Federal Reserve's looming monetary policy meeting. 

The single biggest story of the day, outside of the price reversal (largest high-to-close move since March 2017) was the way the VIX was correlated to stock prices at Tuesday's open. This is a possible regime change because stocks and the VIX traditionally trade in opposition to each other. 

And it marks a potential shift to late bubble behavior seen in 2000 and 2007, when stocks pushed into their final highs alongside volatility expectations. Given the trillions in explicit and implicit short volatility strategies (traders betting against volatility) at the moment, according to Artemis Capital, panicked short covering and broken markets could result. That could lead to, for example, very thin trading volumes in many exchange-traded funds based on short VIX vehicles. 

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This comes at a time when risk appetites have reached their highest level of this cycle, according to Goldman Sachs (chart above). And buying demand is in a lull, with corporate stock buybacks in a blackout period because of earnings season. 

Jason Goepfert at SentimenTrader noted that small options traders -- "dumb money" based on their historical performance -- spent 40 percent of their volume buying speculative call options last week. These are highly risky bets on stocks continuing to rise. That activity was at the highest level since 2011. Since the 2009 low, only five other weeks showed a similar dynamic. Two weeks later, stocks were lower each time. 

On Wednesday morning, U.S. stock futures were up strongly again, but given Tuesday's action and the undercurrents threatening the bull run, watch for a nasty pullback soon on Wall Street. One that has been delayed for years.

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.