Correlation breakdown - stocks, volatility links crack

The traditional inverse relationship between stocks and options -based measures of implied volatility has broken down in recent weeks, and in some cases is now the weakest in years.

Afraid of missing out on a year-end rally, investors are now paying a premium for equity ‘call’ options over ‘puts’. The VIX has fallen recently to near a two-month low even as the S&P 500 has surged into the green and lurched back into the red. The correlation between the two - almost always negative - has turned positive on 10- and 15-day measures.

This is also playing out across the Atlantic, where the sensitivity of volatility to moves in euro zone equities is at its lowest in 10 years, according to Pascale and his colleagues.These developments are unusual, especially with the S&P 500 in a bear market and considering the economic and financial storm clouds that are gathering on the 2023 horizon.

This shows that the premium for ‘OTM’ put options over ‘OTM’ calls is historically low. It suggests investors are paying the least since 2009 to protect themselves against - or take advantage of - an outsized fall on Wall Street versus an outsized rise.

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