Wall Street is primed for a big series of moves in stocks, with traders eyeing a Federal Reserve rate decision, big tech earnings, and next week's midterm elections.
Traditional risk gauges, however, are moving lower, while options activity suggests investors are paying less to protect their index positions heading into the market's crucial late autumn stretch.
That action contrasts with a notable jump in the implied volatility of individual stocks, suggesting the market's bet on near-term disruption is heavily concentrated in megacap tech, the S&P 500's heaviest weighted sector, heading into the final weeks of the year.
The Cboe S&P 500 Dispersion Index, which tracks the implied volatility gap between individual stocks and the benchmark index, has jumped nearly 25% over the past six weeks, reaching its highest level since early August on Monday.
That suggests investors are expecting far bigger moves from companies like Alphabet, Microsoft, Amazon, and Apple -- all of which report September quarter earnings over the next four trading days -- than they are from the broader indexes themselves.
The Cboe Volatility Index, better known as the VIX, is still trading at a muted level near 17.30 points, pricing in relatively contained daily index swings of around 1.1% over the next month. At the same time, options traders have seen implied moves for the S&P 500 compress notably from last week's close.
"The week may therefore be priced as a set of separate company events rather than as one index event, even though the macro calendar inside it has not changed," said Saxo Bank's investment and options strategist Koen Hoorelbeke.
Michael Kramer, founder of Mott Capital Management, thinks the gap between the Dispersion index and the VIX, which has widened by roughly 10% over the past week, will begin to reverse once the Fed decision and big tech earnings are behind us.
What happens to the market's plumbing after that, however, is just as critical.
Heading into a major earnings week, investors buy single-stock options to hedge their exposure, forcing the market makers who sell those contracts to take offsetting positions to remain broadly neutral.
Once results are out and uncertainty clears, that single-stock volatility quickly deflates. That leaves dealers with little choice but to buy back underlying shares to unwind their hedges, feeding a typical post-earnings tailwind for individual stocks.
Yet with broader index volatility so subdued, that dynamic creates a secondary risk.
If the market starts to move in lockstep and single-stock volatility deflates, dealers may have to sell index futures to keep themselves protected -- counteracting that post-earnings rally.
"Falling single-stock volatility usually lets hedges unwind, and the buying that follows supports the market," Kramer noted. "However, if correlation rises, hedging flows on the index may turn negative, pushing the index lower to keep index volatility supported."
That might complicate markets over the coming weeks, of course, but Wall Street is still betting on a solid finish into the end of the year.
Midterm election results will, however, challenge that view, as the nonpartisan Cook Report expects Democrats to flip control of the House of Representatives but sees the Senate race as too close to call.
"It's well understood that midterm election years bring weakness to equity markets," said Morgan Stanley's chief U.S. equity strategist Mike Wilson. "It's also understood they tend to lead to strong equity markets once they are over. We don't see why this time is different.
"Markets loathe uncertainty and so just having it behind us can provide a positive catalyst no matter what the outcome," he added.
We'll see if the volatility story does the same.
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