This week saw a significant shift in the volatility landscape, with VIX open interest hitting its lowest level in nearly two years. For traders keeping a close eye on market sentiment, this development is a clear signal that the dynamics around volatility hedging and options strategies may be changing.

According to Brian Garrett at Goldman Sachs, there are several key factors contributing to this drop in open interest, particularly around call option expiries. As he notes, “with the fact that dealers are ‘less short’ VIX upside to the street, you can get even more comfortable with short skew trades (barrier puts, etc).” This insight is particularly important for those employing volatility-related strategies, as it suggests a potential shift in how the market is structured.

Understanding the Dealer Positioning and Its Impact

To unpack this, let’s first consider the role of dealers in the VIX market. Dealers often hedge their positions by taking on the opposite side of trades from the street. When traders bet on rising volatility, dealers usually go short VIX upside (betting that volatility won’t rise significantly) to balance the market. However, with this week’s expiries, dealers now find themselves “less short” on VIX upside.

Why does this matter? Garrett’s analysis implies that when dealers are less exposed to the risk of volatility spikes, there’s less need for them to aggressively hedge against a major volatility event. This creates a more favorable environment for certain trades, such as short skew strategies like barrier puts, where traders bet on a decrease in volatility.

Skew and the Road Ahead

Skew refers to the difference in implied volatility between out-of-the-money options and at-the-money options. When skew is high, it indicates heightened demand for protection against extreme market moves. But, as Garrett highlights, it may now be difficult for the current levels of skew to persist. He notes, “post-election and barring an unknown unknown, I think it will be difficult for current levels of skew to sustain without dealers being forced to hedge the VIX 80 slide.”

In simpler terms, without a major market-moving event or a sharp spike in volatility, the current elevated skew might be unsustainable. This gives traders more confidence in fading skew—essentially betting that volatility expectations will decrease, rather than increase, in the near term.

What Traders Should Watch For

As VIX open interest drops and dealer positioning shifts, traders should be mindful of a few key points:

1. Short Skew Opportunities: The current market setup may provide favorable conditions for strategies like shorting skew, particularly in the form of barrier puts.
2. Less Need for Dealer Hedging: With dealers no longer needing to hedge as aggressively against volatility spikes, this could result in a calmer VIX market unless an unexpected event shocks the system.
3. Focus on External Events: The upcoming U.S. election and any potential geopolitical or economic surprises could still create volatility, so traders need to keep an eye on external risk factors that could push volatility higher.

The drop in VIX open interest to a two-year low signals a changing environment for volatility traders. With dealers less exposed to volatility spikes and skew at elevated levels, now might be an opportune time to explore short volatility strategies. However, as always, traders should remain cautious of unexpected events that could disrupt these trends.

Brian Garrett’s insights point to an evolving landscape, where the dynamics of volatility hedging may offer new opportunities for savvy market participants. Whether you’re trading barrier puts or watching for changes in skew, it’s clear that the volatility market is entering a new phase—one where careful strategy and timing will be key.