One of the main features of the year 2022 is the spot/vol (by strike) dynamics of S&P 500 (see graph below), a valid question is: 𝗪𝗛𝗘𝗡 𝗪𝗜𝗟𝗟 𝗧𝗛𝗔𝗧 𝗘𝗡𝗗?
The very specific 2022 dynamics are due to the massive size of short VKO (Vol Knockout) puts in the market. This position means that dealers get longer and longer SPX variance as the market goes down (as the moneyness of the put increases). Two main events may change those dynamics.
𝟭/ 𝗧𝗵𝗲 𝗻𝗮𝘁𝘂𝗿𝗮𝗹 𝗲𝘅𝗽𝗶𝗿𝘆 𝗼𝗳 𝘁𝗵𝗼𝘀𝗲 𝗩𝗞𝗢 𝗽𝘂𝘁𝘀.
VKO puts have a maturity of 3 months to 18 months. The ones that were issued end of 2021 are deeply in the money. So are the source of a lot of variance selling. As they come to maturity, they will give big payouts to the buyers since the realised vol over the life of those puts has been very moderate and below the KO level. Once they matured, even new issuance will have less impact on the dynamics, unless the S&P keeps falling so that the “inventory of dollar moneyness” is maintained constant.
𝟮/ 𝗧𝗵𝗲 𝗰𝗿𝗮𝘀𝗵!
If S&P500 crashes, then most VKO Puts will be KOed, and the dealers will need to buy back their short variance hedge in panic mode. That would mean a violent reset of the full S&P vol surface, and the end of the spot down / vol down dynamics. It is obviously a scenario that neither the buyers of the VKO puts nor the dealers want to see!