S&P 500 analysis: The VIX posted its strongest spike in history

The volatility index (VIX) represents implied volatility of the S&P 500 over the next 30 days. So the fact that it rallied to its highest level since the pandemic on Monday surely would have caught many by surprise. Traders the world over use it to help manage the risk of their portfolios, and if it rises too high and too fast, they tend to liquidate positions to reduce their market exposure. With the Nikkei plunging over 12% during Asian trade, it sparked a wide selloff of global assets which seemed to pushed the VIX up further as part of a highly bearish and contagious reaction.

Most notably, the VIX cash market rose 181 points on Monday, its largest single-day spike on record. Yes, it even surpassed the 173.5-point spike in October 2008 at the depths of the GFC. VVIX, which is implied volatility of the VIX, rallied 40.7 points to a daily high of 192.49 – its most volatile level since the pandemic.

The question now is whether volatility will continue to rise from here, or it will be just another blip and we revert to risk on. I suspect it will be somewhere between these two extremes.

The VIX futures curve remains in backwardation

Backwardation means volatility is expected to be higher over the immediate term and gradually decrease into the future. Usually the curve is in contango, where volatility is expected to increase in the future relative to today.

The decent ISM services report softens the blow of the weak ISM manufacturing and NDP reports, and Fed ‘s Daly said on Monday that the labour market indicators he looks aren’t flashing red. That should dispel expectations of an emergency Fed cut – which markets were trying to price in for next week with a 60% probability. But that doesn’t mean traders will be quick to jump back into the market either. So we could be in for some choppy trade and volatility could remain elevated over the near term.

VIX futures positioning – COT report

It is no surprise to see large speculators were net-short VIX futures, as they spend a majority of their time being bearish on the market. That makes sense most of the time, as volatility tends to be lower most of the time. But as we have been reminded of this week, when volatility explodes it takes no prisoners. And that means the majority of traders were on the wrong side of the move when the VIX surged higher yesterday.

However, some asset managers seemed to know something was up, as they had been trimming their gross-short exposure to VIX futures for the past four weeks. I suspect we’ll see a significant reduction of short exposure by next week's report, which could even see asset managers flip to net-long exposure. But note the drop in ‘asset manager’ volume in recent weeks, which also means this set of traders are not bullish on volatility, but less bearish.

S&P 500 technical analysis:

The market has found some stability after its aggressive selloff found support around the October-low VWAP (volume-weighted average price). Yet the heavy daily trading volumes show initiative trading activity near the lows. And that means prices either need to drop soon to justify the bearish exposure of these late comers, or prices could rise further as bears close out their shorts and fuel a counter-trend move.

The 1-hour chart shows prices are drifting higher with thin volumes during the Asian session, and shows the potential to retest the HVN (high-volume node) at 5358.50. But to expect a sustained rally, we really need to see bullish volumes increase. And until then, the bias is to fade into strength in anticipation of its next leg lower. Bears could seek to fade into resistance around 5358 or the weekly pivot point around 5440.

-- Written by Matt Simpson

Follow Matt on Twitter @cLeverEdge