We deemed it inevitable about six weeks ago, and the S&P 500 Index (SPX) broke through the 4,000 level today. At the time, we noted that traders can be fixated upon round numbers and that once they appear on the horizon, those numbers often become self-fulfilling targets. We noted that 4,000 was one of a series of round numbers that traders were fixated upon. Interestingly, of the 5 numbers that we noted, SPX was the last to reach the target. It is fascinating to see what has become of the key products in that time frame and to consider what this means for traders and investors in the weeks to come. 

Bitcoin, unsurprisingly, was the star. We have long asserted that Bitcoin is a key barometer of speculation and that there was no reason that the speculative fervor surrounding the cryptocurrency was ready to break. The speculative fervor hasn’t broken, and the new round number fixation is $60,000.Yes, bitcoin has rallied about 20% in six weeks!

An even more stunning market move over the past six weeks is to be seen in 10-year US Treasury yields. At the time, investors were contemplating the effect of a rise from 1% to 1.25%.  We shrugged off the idea that the Federal Reserve would be concerned with a relatively minor bump in long-term rates, and bond traders seem to have agreed. We have since blown through that level to test the 1.75% mark, resulting in one of the worst quarters for 10-year notes in quite some time. The magnitude of the price move was not nearly as great as that seen in bitcoin, but bear in mind that the Treasury market is magnitudes larger than the cryptocurrency market. Treasury rates are a key component in a wide range of investment decisions.

Yet after a few hiccups, stock indices resumed their advances even as bond yields rose. The market leadership may have changed, favoring banks and cyclical stocks over high-flying tech names, but the broader upward trends remained largely in place. Now that we have achieved yet another round number goal for the stock market, we need to look for clues about what could drive the indices in the weeks to come. As a long-time options trader, I look to the volatility markets for guidance.

Then as now, we noted that the CBOE Volatility Index (VIX) had dipped below the 20 -evel. Interestingly, that dip also occurred on the day prior to a 3 day weekend for traders in the US. The key difference then was that the index just squeaked under the 20 level, whereas today we have plunged below 18 after a few closes in the high 19 range. Although I have been adamant in declaring that VIX is not now, nor has it ever been the market’s fear gauge, there are tools we can use to look inside VIX composition to see whether changes in hedging or speculative behavior are driving the changes to VIX.

When we last looked at VIX in this manner about a week ago, we noted that the decline in VIX was largely attributed to a lack of desire for below-market options. Those represent protective puts, used for hedging. A decline in the implied volatilities of those options can indicate a more sanguine market. That is indeed what we see today. The chart below shows volatility surfaces for 1-month options – those used to calculate VIX – at different points in time:

Volatility Surface for SPX 1 Month Options, 1 Month Ago (red), 1 Week Ago (green), Today (white)  With Changes vs 1 Month Ago (bottom)

(Click on image to enlarge)

Source: Bloomberg

We can see quite clearly that the implied volatilities of above-market options – primarily speculative calls – have stayed at relatively firm levels, while those of below-market options have plunged. As of last week, the fall in at-money implied volatility was modest, though it has accelerated in recent sessions.

The question ahead of us is whether traders are getting too sanguine. Hindsight shows that traders were indeed too fearful a month ago. Their bearish hedges didn’t pay off. Contrarian investors would assert that a decline in hedging activity raises the risk level for markets as a whole. That lack of demand for hedges indicates a greater tolerance for risk and less protection for investors if the market dips. A more bullish trader might read the dip in VIX as an “all clear” from the markets. In the short term, both can actually be correct, though the longer term will separate those views.

As we did six weeks ago, Japan’s Nikkei Index could provide perspective. That index pierced the 30,000 level for the first time in nearly three decades. However, the index has traded sideways over the past few weeks, closing at 29,388.87 today. That milestone high led to a period of consolidation. It remains to be seen if SPX requires something similar before continuing to new heights. In the meantime, options traders are unconcerned about anything worse.