This is Very Unusual, but Stocks Are Taking the Elevator Up and the Escalator Down

In the world of finance, a well-known adage states that stocks ascend gradually but plummet rapidly, symbolized by the metaphor of an escalator moving up and an elevator descending. This conventional wisdom suggests that bull markets unfold over an extended period, while market corrections tend to be swifter. However, recent years have witnessed a striking departure from this established pattern, as highlighted by Mandy Xu, the Head of Derivatives Market Intelligence at Cboe Global Markets.

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Xu's analysis reveals a noteworthy shift in market behavior since 2022, where upward movements in the stock market have displayed more abrupt and forceful characteristics than downward trends. Intriguingly, as of the onset of 2024, the measure of upside volatility in comparison to downside volatility, commonly termed "realized skew" in derivative market parlance, has reached its most negative level in over two decades. This stark deviation is reminiscent of the year 2002 when the S&P 500 witnessed a substantial 23.4% decline following the bursting of the dot-com bubble.

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The expression "taking the escalator down and the elevator up" has become a fitting description for this unconventional market behavior, with the trend intensifying in 2024, according to Xu's comprehensive report. Despite being published before a recent market downturn, Xu affirms that realized skew has only marginally improved since the S&P 500's 1% daily drop, lingering at -2.3. This places it on track to be the lowest annual reading since 2002 when skew plummeted to -4.

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Xu elucidates that realized volatility skew is a statistical metric comparing the standard deviation of upward market movements to downward ones, measured in volatility points akin to the well-known Cboe Volatility Index (VIX). While the VIX gauges expected market volatility based on S&P 500 options activity over the next month, realized volatility provides a retrospective assessment of actual market volatility.

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The implications of this unusual market behavior extend to the realm of options trading, shedding light on the preference for bullish call options over bearish puts. Xu's research underscores that options traders are responding to the evolving dynamics in the market rather than adhering to conventional wisdom. Notably, the demand for out-of-the-money put options relative to out-of-the-money call options, known as implied skew, reached its lowest point in a decade after Nvidia Corp.'s robust earnings report.

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Prominent figures in the derivatives market, including Charlie McElligott from Nomura, interpret this phenomenon as a manifestation of investors' "fear of missing out" on further market gains. McElligott characterizes options market activity as an anticipation of a "crash up" while downplaying the likelihood of a market crash. In alignment with Xu's findings, options traders seem to be reacting to the market's recent trajectory rather than speculative fears.

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An interesting historical context emerges as Xu notes that implied volatility remained relatively subdued in 2022 despite a prolonged market decline, showcasing a rare selloff that didn't trigger a VIX surge associated with market crashes.

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As of recent trade, U.S. stocks are on the rebound, attempting to recover from earlier tech-driven losses. The S&P 500, Nasdaq Composite, and Dow Jones Industrial Average are all reflecting positive gains, contributing to the ongoing narrative of a market that, by one measure, has been experiencing its most consistent rally since 1971.

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In conclusion, the inversion of traditional market dynamics observed by Xu highlights the evolving nature of financial markets and the need for investors to adapt to unprecedented trends. The peculiarities in volatility dynamics and their impact on options trading underscore the importance of a nuanced understanding of market behavior for successful investment strategies in today's rapidly changing financial landscape.

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