CBOE’s volatility expert Mandy Xu sees more record market gains next week

Summary of YouTube Video:

Key Concepts:

• VIX (Volatility Index)
• Realized Volatility
• Volatility Risk Premium
• Fed Rate Cuts
• Tariff Deadlines
• Volatility Term Structure
• Nonfarm Payrolls
• Pain Trade
• Macro Fundamentals

1. Low Volatility and Market Fundamentals:

• The VIX is below 15, the lowest since February. Bond volatility is also low.
• Mandy Hsu argues that low volatility across asset classes indicates a fundamentally driven market, supported by better-than-expected economic data and earnings.
• This contradicts the narrative of market complacency and impending pullback.
• "It's a sign that economic data continues to come in better than expected. And earnings are holding up much better than expected as well."

2. VIX Level vs. Realized Volatility:

• Simply looking at the VIX level can be misleading.
• The VIX should be evaluated against realized volatility (actual historical volatility).
• Currently, realized volatility is around 6%, a one-year low.
• The volatility risk premium (the difference between implied volatility, as measured by VIX, and realized volatility) is actually near a one-year high.
• This suggests options traders are pricing in some risk despite the market's upward trend.
• "VIX at 14th May be low. But the realized volatility in the market right now we're talking about six right 6%. That's at a one year low. So actually the spread the difference what we call the volatility risk premium or how much additional risk premium that option traders are pricing in for the forward outlook. That's actually toward a one year high."

3. Impact of Potential Fed Rate Cuts:

• The impact of Fed rate cuts depends on the reason for the cuts.
• Rate cuts due to deteriorating economic data could lead to stock sell-offs.
• If the Fed cuts due to a tame inflation outlook, it could be a positive catalyst for the market rally.
• The key is the underlying economic narrative driving the Fed's decision.

4. Tariff Deadlines and Volatility:

• Past tariff deadlines (April 2nd, July 9th) didn't significantly impact options market risk premiums, suggesting they weren't taken seriously.
• The August 1st deadline shows a slight "kink" in the volatility term structure, indicating increased volatility expectations for options expiring on that date.
• However, this is likely due to the coinciding nonfarm payrolls release rather than solely tariff concerns.
• The market anticipates some additional volatility next Friday.

5. Volatility Term Structure:

• The volatility term structure is the graphical representation of implied volatilities of options contracts with different expiration dates.
• A "kink" or "bump" in the term structure indicates higher implied volatility for a specific expiration date, reflecting increased uncertainty or risk associated with that period.

6. Pain Trade and Market Direction:

• Previously, the "pain trade" (the scenario that inflicts the most financial pain on the majority of market participants) was to the upside.
• Now, after significant capitulation and unwinding of hedges, the pain trade is likely to the downside.
• This suggests a potential for a market correction or pullback.
• "So I would say, you know for the past couple of weeks we've been saying that pink trade is actually to the upside. But I do think there's been enough capitulation at this point and enough people kind of throwing the towel on hedges. We've definitely seen that in the options market that I would say at this point, the pain trade is probably to the downside."

7. Conclusion:

While the low VIX suggests a calm market, it's crucial to consider realized volatility and the volatility risk premium. The market's strength is currently supported by strong macro fundamentals. The impact of potential Fed rate cuts hinges on the reason behind them. While past tariff deadlines were largely ignored, the upcoming August 1st deadline, coinciding with nonfarm payrolls, may bring some volatility. The pain trade has shifted to the downside, suggesting a potential for a market correction.