Volatility investors under pressure as US market ‘behaves’ too well

Many institutional investors bought volatility-linked instruments cheaply recently, to cushion against the damage that current macro-economic risks can do to their equities.

The could buy protection cheaply because the Vix index on which many such volatility derivatives are based has traded down to 18 recently, some 60% below last year’s peak in August.

The index reflects near-term expected volatility of S&P 500 shares, and broadly reflects the cost to investors of buying protection against more volatile, falling markets.

But those who bought protection via the Vix are now under pressure regarding their hedges. This is because the physical market has largely trended upwards since mid-December, and carrying the protective positions in case the benchmark falls continues to cost.

Dean Curnutt, (pictured) CEO of Macro Risk Advisors, which helps institutional investors understand and trade market volatility, says: “You have to respect the markets, and currently investors who have bought [the Vix] at 20 are not able to profit from the daily fluctuations in the S&P 500 index. That puts pressure on the Vix. If you are bullish on volatility, there have to be events that create uncertainty in markets.”

The average daily realised volatility of the S&P 500 since mid-December has been 14%. Early this week the Vix index was at 18.

Curnutt says: “You can have a bearish view on something bad materialising in six months, but the market has generally not reacted until it really has to. And every point where the Vix goes down and volatility becomes cheaper to buy, there are bullish stories to suggest why it should be even cheaper.

“If you are a long-only investor who uses derivatives occasionally to hedge, and then the market inches higher, you face some questions. As markets are well behaved for so long, people do forget that financial accidents happen.”

He says some investors are adjusting volatility-based hedges positions more often to mitigate the cost of carry, others are using shorter-dated (weekly) options to express their views.

There have been many negative real world events since 2008, and more are widely expected.

The problem for Vix-derivative holders, Curnutt says, is the equity market has demonstrated “quite an ability to shrug off bad news, with the feeling that no matter how big the problems are, Europe will ‘muddle along’.”


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