Cheap Options Entice as Hedge to Stock Risk
Traders use depressed VIX as an opportunity to hedge record stock indexes inexpensively.
What goes down usually will come back up, although not necessarily right away. So it is with currently depressed market volatility.
As long as global markets continue to grind higher, the CBOE Volatility Index (VIX) could fall below last Friday's low of 10.7, which was reached in reaction to the European Central Bank's decision to lower interest rates.
Since 1990, VIX has traded below 11 on 116 trading days, or 2% of the time, according to Krag "Buzz" Gregory, a Goldman Sachs derivatives strategist. But the VIX could decline further if the stock market is not rocked by unexpected events, he adds. VIX's all-time low of 9.3 was set Dec. 22, 1993.
"What makes the current period stand apart from prior low-volatility environments is that volatility and spread levels are low across various asset classes at the same time," Gregory wrote in a recent note.
Indeed, volatility measures in the U.S. bond market and the currency markets also are at historically subdued levels.
Almost every major equity index in the world is trading at or near historic implied volatility lows. Only Italy, Spain, Japan and South Korea are not trading at depressed implied volatilities, reflecting particular challenges looming over their respective markets.
By some measures, volatility is lower than VIX indicates. The 10-day realized volatility of the Standard & Poor's 500 index is around 4.3 and the one-month realized volatility is 7.6.
"Realized volatility," which measures what happened in the past, controls VIX, which measures "implied volatility."
When the stock market keeps grinding higher, realized volatility declines, which drags down the implied volatilities of VIX and thousands of other securities. VIX is calculated by a combination of puts and calls on the S&P 500 index.
These are well-known facts among sophisticated investors but ignored by most pundits because it defies the superficiality of sound bites. It is easier to say a low VIX indicates investor complacency, suggesting only a nutter would be sanguine with stocks at record-high price.
The truth is that VIX is Wall Street's equivalent of a Rorschach test. What people think VIX means says more about those people than anything VIX might be telegraphing.
Investors actually are responding to the low VIX by calmly amassing positions that would increase in value if VIX surges higher, which could occur if the stock market falls from its lofty heights. This bearish trading contradicts recent articles and analysis contending VIX's low reading means investors are blithely ignoring risks.
The hedging action shows the only thing VIX really means is that options prices are inexpensive. Puts and calls on many stocks are trading at the lowest levels on record. This fact has attracted far less attention than the more easily understood fact that VIX traded at its lowest level on Friday since the credit crisis.
Hence, many investors are buying inexpensive options to hedge historically high-priced stocks. Hedging action is heavy in bearish puts on the S&P 500 index and SPDR S&P 500 Trust (ticker: SPY ), the exchange-traded fund that tracks the big-cap benchmark.
Over the past 10 days, investors have prepared for calls on the VIX to increase in value. They have bought July 20 calls, June 16 calls, and September 20 calls. These options will increase in value if the VIX, which recently traded around 11, essentially doubles in value, which would happen if the stock market plummets.
Similar hedging is occurring in the S&P 500 and SPDR ETF. Of the top 10 positions in SPY options, which many investors use to hedge or speculate on market moves, all but one of the most widely held contracts are bearish puts. In fact, even though the S&P 500 is at record highs, options trading is decidedly cautious. Of the 18.6 million contracts outstanding, 13 million are bearish puts.
The positioning is a reminder that volatility behaves like a rubber band. Investor fear causes volatility—and VIX is the primary measure—to stretch out. During the worst of the credit crisis, VIX rose to a high around 90, before ultimately dropping to its long-term average around 19. Many investors sold options in anticipation of the decline.
Now, investors are buying VIX calls, or hedging portfolios with stock indexes at historic highs. That continues to be a savvy bet.
