Stock markets appear calm, but sudden volatility spikes reveal underlying fragility

Financial markets may look steady on the surface, but recent events reveal underlying problems that worry Wall Street experts. A sharp jump in fear gauges during what seemed like a minor market drop has sparked fresh talks about how easily things can go wrong.

The trouble began on October 16, when a key measure of market fear, the Cboe Volatility Index, reached its highest point in six months. This happened despite the S&P 500 Index only falling by 0.6 percent that day. Investors were concerned about potential loan issues at smaller regional banks.

What made this event unusual was the significant movement of the fear index compared to the actual stock market drop. UBS Group AG experts say this reaction was larger than what occurred during major market scares in August 2024, the February 2018 “Volmageddon” crash, and even the chaos that followed Lehman Brothers’ collapse in 2008.

Technical trading issues amplify market stress

UBS experts, including Kieran Diamond, explained what went wrong. They found that people who sell options on S&P 500 stocks actually made things worse on October 16. As the market declined, these traders became increasingly vulnerable to significant price volatility. When they attempted to protect themselves by buying back their positions, it caused the fear index to jump even higher.

Bank of America Corp. experts believe the jump was primarily caused by technical trading issues rather than genuine market concerns. They wrote in a research note that exchange-traded products linked to volatility didn’t play as big a role as some thought. This is because investors took their profits while market makers covered their bets.

The Bank of America team calculated that if the VIX futures increased by 10 points, only about 17 percent of people holding volatility products would need to sell to offset what dealers were doing.

These sudden bursts of fear in otherwise calm markets point to a bigger problem made worse by the huge growth of exchange-traded products.

On one side, some funds make money by selling options and collecting fees, which helps keep volatility low. On the other side, leveraged exchange-traded funds use complex trades to deliver promised returns on the S&P 500 and Nasdaq 100 Index, or on individual stocks that have big effects on these indexes.

Leveraged funds create new risks for the financial system

“When I think about the VIX spike and the broader liquidity stress tied to leveraged products, what concerns me most is the potential for negative feedback loops driven by rebalancing in 2x and 3x ETFs,” said Garrett DeSimone, head quant at OptionMetrics, talking about the October 16 volatility jump.

Leveraged stock funds have become a hot topic, especially when it comes to popular individual stocks like Nvidia Corp. and Tesla Inc., which retail investors love to trade. The debate centers on how these funds impact markets when they rebalance their holdings daily, typically near market close, especially when volatility is high and trading is more challenging.

The worldwide market for leveraged exchange-traded funds is worth about $160 billion in total value. The top 10 stocks make up roughly 65 percent of this amount, according to Antoine Porcheret, who heads institutional structuring for the UK, Europe, the Middle East, and Africa at Citigroup Inc.

When big price moves happen, some single-stock funds might buy or sell shares equal to 100 percent or even 200 percent of the normal trading volume at market close, “which is clearly going to impact price,” he said. He also noted that banks, which are the ultimate partners in these trades through swaps with fund providers, face around $300 billion in stock market risk from leveraged funds.

But banks face another danger called gap risk. If a company went bankrupt, its stock price could drop to almost zero, causing a 100 percent loss for a 2x leveraged fund. In that case, the protection banks hold would be down twice as much.

Banks typically mitigate this gap risk by selling various types of complex and simple derivatives to large clients. This doesn’t create ongoing balance sheet risk like in past crises when banks had major exposure from derivatives like variance swaps.