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How moves in the VIX can make market makers fearful

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Steve Sosnick, Interactive Brokers chief strategist, joins Yahoo Finance to discuss what the moves in the VIX say about the market.

Video Transcript

[MUSIC PLAYING]

- This is Yahoo Finance Live. We are looking at futures that have been pointing to a slightly lower open, until now. Now they've switched around, and they're indicating a very slightly higher open, perhaps building on the big gains that we saw yesterday in the major averages.

Let's bring in Steve Sosnick, he's Interactive Brokers chief strategist. And Steve, one of the similar themes-- that we talked about a few weeks ago-- has to do with the sort of divergence between what we would normally expect from the VIX at a time like this, and what's happening underlying in stocks. And that is we still see a relatively elevated VIX, and an elevated VIX curve, at the same time that stocks are rallying. Which is confounding to some people. And as Miles has been talking about frequently, it caused Marko Kolanovic-- over JP Morgan-- to say maybe we're seeing even a bubble in the VIX. So I'm curious, first, to get your thoughts on that kind of talk.

STEVE SOSNICK: As much as I respect my colleague at JP Morgan-- my colleague, he's a much more renown strategist than I am-- he-- I'm going to push back on him, on this one. Because this one-- there's a couple of elements that I think he's missing, in terms of the VIX. And this is where having been a trader for so many years comes into play.

Part of the thing with-- part of the thing that I think people look at. You know, he was saying that it's very high relative to historical volatility. As far as I know, he was using close-to-close historical volatility. And if you want an example of how that fails you, think about a day like last Wednesday where we were plunging for most of the day, and then closed essentially unchanged.

Well, if you're using close-to-close historical volatility, that registers is about a zero and goes into the calculations going forward as roughly a zero. The problem is if you're a trader, you're looking at that day as saying that was an incredibly volatile day. I'm using-- I'm going to use a high-low volatility calculation-- which is sorry to be truly esoteric, here-- but I'm going to worry about whether I can make money trading-- trading my gamma, hedging my portfolio, when buying low, selling high. And I'm going to plug a 2% volatility into that equation, which is what we saw. That equates to a 32% annualized volatility.

So that's part one. So depending on whether you're just using straight historical close-to-close volatility, VIX is always going to look high. Because the professionals, who trade the options that would make up the VIX calculation, are using the high-low volatility. Because that's how they trade.

Secondly, below-market option-- the VIX takes a wide range of options, so below-market options have always kind of pushed up the VIX. They have since 1987, when the world kind of realized that they needed a little bit of downside skew. And it was better to hedge with options than trying to sell futures into a down market. The difference now is-- and I hate to use the term "it's different this time," because those are extraordinarily dangerous words-- but right now, what we see is with all this call speculation, upside calls are also pushing up the VIX. They actually used to have a slightly depressing effect on VIX.

So you've got that combination working in as well. The latter part may or may not be sustainable, longer term. But as long as we see demand for calls, we're going to see an extra premium-- that we see on VIX-- over what we normally see over close-to-close historical volatility.

- Steve, in a way of saying this in more layman's terms-- if that's possible for volatility, and that kind of stuff--

STEVE SOSNICK: Sorry.

- Are markets just-- are markets just simply looking at a-- or are traders anticipating just a different market environment now, than they were two years ago? And is that going to maybe alter a lot of these comparisons that strategists are trying to make? And themes they're trying too outline to their clients, when clients ask what's going to happen to the stock market?

STEVE SOSNICK: Yeah, it's interesting because at the same time you sort of have-- you've had the Fed more or less pressing on volatility for some time. Because with the amount of-- I'm going to call it-- the stimulus, and everything else, that should have in some ways a suppressing effect on volatility. But I think it's gotten so extreme that we're seeing the opposite.

And again, what we're seeing now that we really have never seen before-- maybe for a short while in 1999-- was this crazy speculation in calls. And what's happening now is markets adapt to that. If you're a call writer-- which a lot of, I assume, people who watch this are-- you're going to demand extra premium for the calls that you write. The market makers, certainly, are doing so.

And so you are seeing a different environment now. Whether that's a permanently different environment, that remains to be seen.

- And then we had the opening bell on Wall Street. Yet another SPAC, TCW, ringing that opening bell. Steve, let's look at the market from a 100,000-foot view. And I'm sure you have seen the new ultra-millionaire tax put forth by Elizabeth Warren, yesterday. 2% annual tax on net worth of households and trust between $50 million and $1 billion. What-- do you think that has any impact on the market? And I ask that from the direction-- perhaps the market doesn't understand how much taxes-- corporate taxes, perhaps even individual taxes if there's a tax on trading-- maybe that comes into effect somewhere, finally, under the Biden administration within the first two years. And stocks at these levels don't properly reflect that reality.

STEVE SOSNICK: Well, Brian, I think a wealth tax is going to be a very tall order. I think-- you know, think about who pays the lobbyists. And I have a feeling that's going to be a tough one to get through. I think in the-- you know, I think in terms of transaction taxes, that's going to be a tough one as well. I think it would really throw sand in the gears of the market, if you got that through.

I think right now-- and sort of in many ways this ties back to the original question from Julie-- is the VIX futures are showing an elevated level out into April and May. And I think that has to do with the more basic income taxes that people have to pay. I think market makers are fearful that the public, who've been successfully speculating, will have to take money out of the market to pay their regular income taxes. Because I think that people are going to be somewhat astounded by their tax bills if they've been trading successfully. And investing short term, as many people have.

So the 100,000 foot view? That's a tough one. Right now, the one thing I'd say more than anything, is what's the thing that makes me most fearful is the lack of fear itself. But I think in terms of the specific taxes, I'm going to say that let's get through April 15th tax season first. And then start to worry about some of that stuff, which really can upset the apple cart if they come in, in many ways.

- Hey, Steve, is the futures curve are also elevated because of inflation and/or bond yield concerns? Maybe fear is too strong a word, since we're looking at a strengthening economy too. But how much are we to make of, what seemed to be-- tantrum, again, too strong a word-- but these sort of blips in the market that are caused when we see an uptick in yields.

STEVE SOSNICK: I'm going to call it a pretantrum. I think people are starting to worry that there could be the taper tantrum. We have a lot of Fed-speak this week. I think the chairman was very clear to say that we're not raising rates-- we're not raising the inflation rates until we see the whites of their eyes, kind of thing. But let's see what the other Fed governors have to say when they speak, this week.

I think one and a half isn't enough, necessarily, to get people worried. I think one seventh-- one add 3/4, too, is probably the next level of worry. I think what surprised people was-- I think along the way, people expected the Fed to intervene in the longer-term rate curve when it got to one, or when it got to one and a quarter, or one and a half. And we haven't seen that. And I don't think they have the inclination to do it. I think that adds a little bit of risk back to the market. But not in a really unhealthy way, because-- again, what we're talking about is strange way a risk from a strengthening economy. And I think, ultimately, everybody wants a stronger economy, even if it may have unanticipated effects on the marketplace. On the stock market, per se.

- Steve Sosnick, Interactive Brokers chief strategist. Thanks so much to you, and to your point Lael Brainard of the Fed speaking at 1:00 PM today. So even though she didn't talk about this issue yesterday in some comments, we will see if she does today.