Traders may be a bit too relaxed about the risks facing the stocks market heading into the end of the year, and that could come back to burn them.
Speculator short bets on Cboe Volatility Index futures contracts hit a record high last week, data compiled by the Commodity Futures Trading Commission shows. The VIX, which is widely considered to be the best volatility gauge in the market, also hit its lowest level since July on Friday, around 12. It bounced back to trade near 13.
This short positioning in VIX futures came as U.S. stocks hit all-time highs.
Typically, when markets are at a record high, traders tend to load up on VIX calls to bet on a pullback. But this time, they are betting on further stock gains and even lower volatility as the VIX sits near its low of the year. This optimism raises concern that the market might be ripe for a correction given trade deal uncertainties persist.
"With a full-blown trade agreement still likely many months out into the future if at all, it's a little hard for me to take there's this much optimism," said Randy Frederick, vice president of trading and derivatives at Charles Schwab. "When you see a huge amount of complacency and excessive optimism especially from certain participants in the market, that's when you oftentimes tend to get a snapback in the other direction."
The Dow Jones Industrial Average joined the S&P 500 and Nasdaq Composite in record territory last week, rising more than 1%. The 30-stock average also posted its third straight weekly gain. The S&P 500 and Nasdaq, meanwhile, hit fresh record highs on Friday. The S&P 500 also posted its fifth-straight weekly gain while the Nasdaq notched a six-week winning streak.
Renewed hopes for a U.S.-China trade resolution gave stocks a boost in the past month. The Dow and S&P 500 are both up more than 3% in that time while the Nasdaq has gained nearly 5%. Expectations that the Federal Reserve will keep interest rates low have also lifted stocks.
Both sides agreed last month to finalize a so-called phase one trade deal, which is expected to be signed later in November. Optimism around trade was further lifted last week after multiple reports said China and the U.S. agreed to roll back tariffs as part of that deal.
The improved tone around trade also contributed to a spike in bets against volatility. Noncommercial traders, or speculators, have ramped up their short positioning in VIX futures to a record high of approximately 207,000 contracts, according to Nomura.
However, the risks to the market remain out there. President Donald Trump said Friday that he had not agreed to remove tariffs on China, contradicting previous reports. Also, China and the U.S. have not agreed on a venue for the phase one deal signing. Both countries have also come close to signing some sort of deal in the past before talks fell apart or suffered a setback.
"Volatility is best summarized as a powder keg based on the narrowing of dispersion," said Andrew Thrasher, founder of Thrasher Analytics, in a note. "The short-term risk is elevated for a pullback in equities and a material advance in volatility."
"Sentiment has reached excessive bullish levels and volatility is the biggest metaphorical drum being beat from the risk-off drummers," Thrasher said.
To be sure, there are some constructive trends bulls can point to. For example, the participation in this latest rally to record highs has been broad. Ten of the 11 S&P 500 sectors are up over the past three months, with tech and financials gaining more than 9% in that time. The advance-decline line — a measure of breadth among New York Stock Exchange-listed stocks — recently hit an all-time high.
"Everything I've seen the last few weeks I've been pretty happy with. The market breadth has been very strong, which is confirming the move we're seeing in U.S. equities," said Christian Fromhertz, CEO of The Tribeca Trade Group. He noted, however, that complacency in the market may be "a bit high" at this point.
"At this point, we're due for some sort of digestion this week after five weeks of gains," Fromhertz said.