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A strange thing happened with market volatility last week: It went down hard! It is not common to see a volatility collapse in just a week’s time.
The VIX fell more than 30% in five days on heavy selling – a stunning move. At the close Friday, the “fear gauge” closed for a second straight day under the 200 day moving average, a key level for keeping volatility in check. (Crossing above the 200 day moving average is where uptrends begin, and the bulls do not like to see the VIX moving up.)
Why did volatility collapse?
The VIX fell for two main reasons. Pressure from a couple of uncertain outcomes was released. One was the election and the the other was the Federal Reserve’s monetary policy.
Now, for the latter, most traders and investors had a strong feel for what the Fed would do. The Fed funds futures market was projecting a 25bp cut in the funds rate with about 99% certainty on the day before the decision. The committee delivered. (Remember, implied volatility rises when uncertainty and doubt are present. Even though the futures market predicted the exact result, there was a still a chance for disappointment.)
Now the election was a different matter altogether. While the betting markets were pretty much spot on with the winning side (large bets on Trump to win), there was a huge cloud of uncertainty through election day. But once the day was over, doubt was removed and volatility could be sold.
The reason it could have gone down so fast is because volatility may have been overpriced. Traders may have been looking for chaos. When it did not happen, it was a furious move to sell volatility as quickly as possible.
Indices ended the week at all-time highs because traders and investors were ready to buy stocks with the sharp drop in market volatility.
I don’t believe volatility will move up before the end of the year. We are in a seasonally strong period for stocks, and since we are at highs, the dips are likely to be bought. If you are staying long, just keep some protection (puts) handy.
Related: How the Election Could Impact the Stock Market This Week