Flip From AI Rally Chase To Bubble Fear Spurs Options Demand

No matter which way the S&P 500 Index goes after a tumultuous month, options volatility looks to be headed higher.  

The benchmark snapped a three-week run of gains, pushing for a time on Friday the Cboe Volatility Index well above 20, a sign of growing market stress. The pullback in stocks reversed an acceleration to a record high that saw an increase in spot up, vol up days — when share prices and volatility move in tandem, as opposed to the typical inverse relationship between the two. 

A number of factors supported volatility flare-ups in mid-October and last week. Outsized moves seen in single stocks after earnings point to growing fragility in the market. And the lack of US government economic figures leaves macro analysts hunting around for alternate data sources at a time when the Trump administration’s economic policy is, well, volatile.

It all underscores that the summer calm isn’t likely to return to the market, especially with a Federal Reserve rate decision looming in December, the ongoing government shutdown threatening to interrupt air travel and mounting layoffs pointing to a weakening economy. 

“I think investors are well aware of the increase in fragility of the market,” Maxwell Grinacoff, head of US equity derivatives research at UBS Group AG, said by phone. “It takes so little to drive either a down 3% move or a five-point spike in VIX like we saw on the 16th, even though the S&P move was relatively more muted.” 

Pullbacks in the VIX are getting shallower — in October the gauge bottomed just under 16, compared to the lower levels seen in the summer and the rock-bottom levels from last year. Theoretical VIX floors were a topic over the summer, with the gauge maintaining a significant risk premium over realized volatility in the lead-up to Donald Trump’s China tariff threat in early October.

Grinacoff said investors are asking him why the VIX stubbornly refuses to go below 16 or 17 points when the S&P 500 is at record highs. That’s due in part to traders’ appetite to both chase the rally and insure against a drop. 

“Investors were definitely hedging as the market was moving higher,” Grinacoff said, but they’ve kept on buying bullish calls, “the call wings have been super bid as well heading into Q3,” he added, referring to demand for options that benefit from a continued rally in stocks. 

Others point to the impact of the US government shutdown and the knock-on effect of the impasse in Congress on Fed policy as another reason for higher equity volatility.  

“The VIX remains on a higher floor than last year, while a stronger spot-up, vol-up dynamic has emerged amid the chase for upside and US policy uncertainty,” Tanvir Sandhu, Bloomberg Intelligence’s chief global derivatives strategist, wrote in a note.

According to derivatives strategists at Bank of America Corp., volatility rising along with asset prices is among the clearest signs of a bubble. Asset prices start trading on momentum and become disconnected from fundamentals, as seen in the early 2000s tech bubble, the strategists noted, referencing a 2024 research note highlighting that in times of economic disruption, forward visibility on earnings deteriorates, which supports volatility.

A combination of larger realized moves and rally chasing has flattened the call skew on some US single stocks, especially in technology names. 

Similarities between the October AI “melt-up” to the 2000s tech bubble may have prompted investors to bid for upside calls in some of the companies that could benefit from a potential “up-crash” in markets, with “two-way risks” becoming a popular phrase from derivatives strategists. The question of course is what stage the bubble is in, as the mere existence of a bubble doesn’t mean it’s going to pop any time soon.

Options values are likely to be supported by wider market moves, as the S&P 500 30-day realized volatility more than doubled over the past month to the highest since June. 

The VVIX — known as the “vol of vol” — is also rising as investors hedge with VIX options. Some traders early last week were also seen taking off bets on the VIX falling, another sign the market expects volatility to remain higher. 

While single-stock volatility left broader indexes behind in the early part of the earnings season, with the Cboe S&P 500 Constituent Volatility Index hitting record levels compared with the VIX, that’s reversed as macro concerns grow. The current trend is likely to continue narrowing as earnings reports taper off, providing less news flow around single names.

“Upside demand has driven the widening of the spread between single-stock vol and index vol to an extreme,” said Sandhu. “That has started to reverse as the earnings season comes to an end.”