Traders Wager on Calm as Volatility Evaporates
VIX index has fallen 9.4% in April after recording one of the biggest declines in history to start the year
Volatility in the stock market has continued to drop in 2019, a sign that some investors are embracing riskier assets again.
The Cboe Volatility Index, a yardstick for expected swings in equities, has fallen 9.4% this month after recording one of the biggest declines in history to start the year.
The gauge measures the speed and severity of the stock market’s moves and tends to fall when equities are rising and demand for hedges on the S&P 500 slips. Volatility measures tracking currencies, bonds and oil have also retreated.
“Sentiment is incredibly bullish,” said Nancy Davis, chief investment officer at Quadratic Capital Management. “So many people are chasing performance now.”
Ms. Davis said investors have turned to selling options on equities and other assets—income-boosting strategies that typically profit when market volatility stays low.
They also have bet against the VIX, which is akin to taking a bullish stance on stocks. This is a profitable but risky wager that tends to pay out when stocks are rising but can go haywire if sentiment flips.
Major U.S. stock indexes have rallied this year and are on the cusp of fresh highs as Federal Reserve Chairman Jerome Powell said the central bank would be patient with its path of interest-rate increases, leading some to expect a rate cut this year.
Investors also have grown more optimistic about the U.S. economy after worries about its health pulled stocks into a bruising late-2018 selloff. Last week, fresh data showed a rebound in retail spending and strength in the country's labor market.
“We have seen these periods before where the coast is sufficiently clear and market psychology stabilizes,” said Dean Curnutt, chief executive officer at brokerage Macro Risk Advisors, in an email.
The so-called short volatility wagers mark the latest signal of how quickly investors have pivoted toward riskier assets. Market volatility recorded one of the biggest falls in history earlier this year, according to Macro Risk Advisors, and leveraged funds such as hedge funds have steadily ramped up bearish bets against the VIX, Commodity Futures Trading Commission data as of April 16 show.
Wall Street’s “fear gauge” fell from about 36 on Dec. 24 to 17.8 on Jan. 18, one of the fastest drops of at least 50% in history, according to Macro Risk Advisors. The firm calculated the time it took for the VIX to fall by that much after it had darted above 20. The latest incident ranks fourth in the top five, the data show, among other major events that shook markets such as the U.K.’s referendum to leave the European Union in 2016, and the jolt of volatility that hit Treasury markets in October 2014.
Some analysts said the speedy return of calm shows how enthusiastic investors are to execute the so-called short volatility trade, which they said can help keep a lid on swings. As soon as the VIX jumps to a certain level and begins to edge lower, investors race to bet against it.
Though this can be a profitable trade, some cautioned that it can be incredibly risky. Jitters among stock-market investors can drive up turbulence, quickly burning a hole in an investor’s portfolio. That is what happened at several points in 2018. Traders can use VIX futures to make directional bets or hedge other exposure.
Short, or bearish, bets against VIX futures by leveraged funds outnumber bullish ones by about 3 to 1, CFTC data as of April 16 show. The net short positions recently hit the highest level since early October, before stocks started falling toward the worst quarter in at least seven years.
The VIX futures activity shows that some institutional investors are betting that the market is going to go up, said Mark Sebastian, managing partner at Option Pit.
Mr. Sebastian said he has been buying bearish options on a volatility exchange-traded product—contracts that would profit if turbulence stays mild. “I’ve been able to book some decent profits,” Mr. Sebastian said. “I don’t think [volatility] is going up.”