Something incredibly contradictory is afoot: Major stock indexes are falling, red screens are multiplying, but the CBOE Volatility Index ($VIX) and, by extension, long-volatility ETFs like VXX and VIXY, are actually holding steady or falling.
According to classic market logic, when stocks go down, the VIX is supposed to go up. When that relationship breaks down, it raises a bright red flag.
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What does the VIX warn us about?
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So far it is only a short-term phenomenon, but it is worth watching. The VIX fell with the S&P 500 Index ($SPX) over the past few days. It’s not a lasting trend, but it’s more than an isolated incident. And since VIXY is one of the 10 ETFs in my ROAR 10 ETF model portfolio, I’m on alert for even a modest event like that. And I’m sure I’m not the only one.
Part of the explanation is that the VIX does not measure the actual movement of the stock market. Measure the insurance claim during the next 30 days. It’s anticipatory.
When the market experiences a slow, orderly decline rather than an impulsive panic, institutional traders do not rush to buy protective puts. They have already adjusted their positions. Because the VIX is calculated from S&P 500 option premiums, the lack of panic buying keeps the VIX artificially suppressed.
This could be as simple as evidence that institutional trading and hedging activity is a bit complacent. When the market falls and the VIX falls, it means that market participants are treating the sell-off as a temporary and non-threatening event. And with this chart in mind, showing SPY going back 15 years, who can blame them for being complacent?
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This creates a blind spot, where investors assume there are no defaults on the coast simply because the fear gauge is not rising.
The structural red flag: Is there a new ‘0DTE effect?’
The deeper, more systemic warning is what this tells us about market structure.
In recent years, the explosion of short-term options trading (specifically zero days to expiration (0DTE) contracts) has fundamentally altered the behavior of volatility. We even have ETFs that are dedicated to daily covered call writing on the S&P 500, like the Roundhill S&P 500 0DTE Covered Call Strategy ETF (XDTE).
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Big Wall Street firms and a massive wave of popular new funds (like covered options ETFs) are making money by constantly selling “market insurance” to other investors. Think of it as a group of companies flooding the market to sell smartphone insurance because the payouts are high. This massive offering of insurance has created a frenzy that will eventually backfire.
When these large companies sell this insurance, they have to protect themselves by constantly buying and selling the actual shares in the index. This continuous, robotic trading acts as a giant shock absorber. It crushes any normal daily ups and downs, tricking the VIX (the market’s “fear gauge”) into staying low and appearing calm.
To make matters worse, everyone now trades ultra-fast options that expire on the exact same day. Because the VIX only looks at the next 30 days, these same-day options are completely invisible to it. The danger has not disappeared; it just hides where the fear gauge can’t see it.
Additionally, if you buy a VIX ETF hoping to profit when the market falls, you may be set up to lose. These ETFs don’t actually own the VIX; They buy VIX futures contracts.
When the market slowly declines without panicking, next month’s contracts are more expensive than this month’s contracts. To stay open, the ETF is forced to sell low and buy high every day. This constant losing trade consumes cash, meaning your ETF will lose money even when the stock market is falling.
We’re not there yet, but this is a threat to my own “way of life” as an ETF portfolio builder. Sure, I can trade VIXY for an ETF that shorts an index (maybe even with leverage). But VIX-based ETFs get more of that leveraged effect without requiring much capital outlay.
Still, the gauntlet has been thrown down. Historically, when the market pretends that everything is perfectly predictable, it is very unstable. It almost always ends with the financial version of a sudden and violent earthquake. A stagnant VIX in a falling market would be a warning that the eventual collapse will be a dip event, not a slow decline.
Because? Because when volatility is artificially suppressed through systematic selling and structural option positioning, the market appears deceptively stable. Protection is undervalued relative to actual market risk, so the moment a catalyst forces these short volatility managers to unwind their positions, the rebalancing cycle reverses.
The warning sign is not that the market is falling, but that the spring is getting tighter and tighter. When the release occurs, the increase in volume will be sudden, violent, and very disturbing to anyone relying on a low VIX as a safety signal.
I know I am watching this closely, daily, as a trader. But the long-term investor in me (yes, I’m both) is equally concerned, as a systemic market “event” that has a VIX-induced attendant in the manner described above has a very 1987 vibe. As with so many things in today’s markets, it’s a real risk. Not realized, and may not be. But at the end of the day it is a risk.
Rob Isbitts created the Roar Scorebased on his more than 40 years of experience in technical analysis. ROAR helps DIY investors manage risk and build their own portfolios. To view Rob’s written research, see ETFYourself.com.
On the date of publication, Rob Isbitts had no (directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article are for informational purposes only. This article was originally published on Barchart.com
