Investors may be misinterpreting last week’s dramatic surge in the Cboe Volatility Index (VIX), widely known as Wall Street’s “fear gauge,” which spiked to historically high levels not seen since the 2008 financial crisis and the 2020 COVID-19 market crash. However, instead of indicating widespread panic among investors, this extraordinary rise in the VIX may have been driven by a technical anomaly rather than a genuine reflection of market sentiment, according to several Wall Street strategists.
The VIX is commonly used to measure market expectations of near-term volatility, often reflecting investor fear and uncertainty. On August 5th, at approximately 8:30 a.m. Eastern Time, the VIX skyrocketed past 65, capping off its largest intraday swing on record, according to Dow Jones Market Data. This sudden spike sent shockwaves through the financial community, as the index had only reached such extreme levels during periods of profound economic distress. But unlike previous instances, where the VIX surge coincided with deep-seated fears about the global economy, this recent spike appears to have a different explanation.
During the spike, global markets were indeed under pressure, with Japanese stocks experiencing their most significant daily drop since 1987, and U.S. stock futures plunging by 4.4% amid fears of a looming recession and the unwinding of a popular yen carry trade. On the surface, these events seemed to justify the VIX’s meteoric rise. However, some market experts, including Peter Tchir, chief macroeconomic strategist at Academy Securities, quickly began questioning whether the spike was truly reflective of investor sentiment.
Tchir observed that the magnitude of the VIX’s increase appeared disproportionate relative to the actual declines in the stock market at the time. This discrepancy suggested that the spike in the VIX might have been driven by factors unrelated to widespread market panic. After further analysis, Tchir concluded that liquidity issues in the options market may have significantly distorted the VIX’s readings. Specifically, he pointed to the possibility that as markets were tumbling, options dealers widened the bid-ask spreads on certain illiquid S&P 500 options. This adjustment, even in the absence of substantial trading volume, could have artificially inflated the VIX, creating a misleading impression of heightened fear among investors.
To understand how this could happen, it’s essential to consider how the VIX is calculated. The VIX is derived from the bid-ask spreads of S&P 500 options that are set to expire between 23 and 37 days in the future. These options include both calls and puts—where a call option represents an agreement to buy a stock at a predetermined price before a specific expiration date, and a put option represents an agreement to sell at a predetermined price before expiration. The prices of these options reflect market expectations of future volatility, with wider bid-ask spreads typically indicating higher expected volatility. However, when liquidity is thin, especially in out-of-the-money options (where the strike price is below the market level for calls or above it for puts), even small changes in these spreads can lead to outsized moves in the VIX.
In this case, Tchir and his colleagues believe that the spike in the VIX was exacerbated by such liquidity issues rather than a genuine surge in demand for market hedges. Supporting this view, Tchir noted that the front-month VIX futures contract—used by investors to bet on or hedge against future volatility—did not experience nearly the same level of increase as the VIX index itself. This divergence further undermined the notion that the VIX’s spike was a reliable indicator of market fear.
A similar conclusion was reached by a team of analysts at Bank of America (BofA), who shared their findings in a report with MarketWatch. The BofA analysts pushed back against popular theories suggesting that the VIX’s jump was driven by the unwinding of speculative “short volatility” bets, which are trades that typically profit when the VIX falls or remains low. Instead, the BofA team identified a few trades in illiquid out-of-the-money S&P 500 options as the likely catalyst for the dramatic widening of bid-ask spreads across the options chain, which in turn drove the VIX to artificially high levels.
Further evidence that the VIX’s spike was not a true reflection of market fear emerged when the index quickly retreated once regular trading began on Wall Street. The VIX fell significantly as U.S. markets opened, reinforcing the idea that technical factors, rather than a surge in panic-driven trading, were behind the premarket move. By the end of the day, both U.S. and Japanese stocks had already started to recover from their earlier losses, adding further weight to the argument that the VIX’s rise was an outlier rather than a harbinger of deeper market troubles.
Despite the quick reversal in the VIX, both Tchir and the BofA team cautioned that the lack of a genuine capitulation among investors—where panic selling drives markets to a bottom—could leave stocks vulnerable to further volatility in the weeks ahead. Historically, the months of September and October have been particularly volatile for financial markets, and with these challenging months just around the corner, the recent episode with the VIX could be a precursor to more turbulence.
As of Tuesday, the VIX was on track to close below 20, marking a steep 49% decline from its Monday closing high of over 38. This nearly 50% drop in the index represents the largest six-day slide for the VIX on record. Meanwhile, the S&P 500 and Nasdaq Composite were poised to extend their recovery, with both indexes on track for their biggest four-day gains since November.
In summary, while the recent spike in the VIX initially appeared to signal a surge in investor fear, a deeper analysis suggests that it was likely driven by technical factors related to the calculation of the index rather than a genuine reflection of market sentiment. Investors should be wary of drawing conclusions from this episode, as the VIX may not have provided the reliable market-timing signal that some had anticipated. Nonetheless, with the potential for increased volatility in the coming months, investors should remain vigilant and prepared for possible market fluctuations as the year progresses.