Recently we have been discussing with subscribers the elevated implied volatility in the S&P500 due to the 1/5 election events. The VIX is a decent measure of implied volatility in the S&P, and you can see that despite the market being at all time highs, the VIX was well off lows.
Our feeling was that after the event implied volatility (i.e. the VIX) would drop, and that would force a rally in stocks. This is due to options vanna. Options prices are very sensitive to implied volatility, and when implied volatility drops the value of options, particularly puts, declines.
Therefore if options dealers hold an inventory of short puts, those puts lose a lot of value. Keep in mind these dealers are likely short futures against that short put position. So when their puts lose value they can buy back some of their short futures position, and this pushes the stock market higher.
You can see in the chart below that VIX (red line) dropped sharply into the AM session, and the S&P500 (blue) rocketed higher. VIX then stalled out for the remainder of the day, as did the velocity of the stock rally.
Options vanna works both ways. You can also note in the afternoon that the VIX spiked sharply on put buying, following the events in Washington DC. As implied volatility spiked, put values increased and that likely led to dealers hedging by shorting futures.
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