The question has become central as spikes in the Cboe Volatility Index have grown increasingly ephemeral.
Consider
what happened last week, when the gauge surged more than 2.3 points
intraday on two instances as concern increased over the escalating
conflict between Russia and Ukraine. By the close, the VIX was up less
than 1 point.
More
dramatically, the measure of expected stock swings climbed by a record
during the Aug. 5 volatility shock before giving up almost all of its
gain within a week. The front-month future rose far less that day.
With
the market increasingly deeming bad news as an outlier tail risk,
investors are left wondering how effective volatility hedges truly are — or the practical value of having them as monetizing any move nowadays requires very quick profit taking.
So-called vol-of-vol is
typically very high during market stress, meaning that a spike in
volatility can quickly turn into a collapse — which has also proved hard
to profit from lately.
“VIX calls can be exceedingly challenging to monetize,” said Jeremy Wien, managing partner at Moo Point Capital Management for its equity-index volatility fund.“Having said that, VIX has the ability to spike faster and more sharply than the equity markets fall, so VIX calls can be quite a useful hedge in certain scenarios.”
VIX
calls could be better to protect against geopolitical events, while
S&P 500 puts might be preferable to hedge against softening economic
data, disappointing earnings or declines in stocks related to
artificial intelligence, Wien added.
In a recent research note, Bank of America Corp. strategists including Matthew Welty said hedgers
looking to pick VIX calls or S&P 500 puts need to to consider how
reactive the gauge of swings is likely to be as equity slumps may not
necessarily come with a spike in volatility. They noted the VIX
options market built up a significant imbalance over 2023 and 2024 that
may have not completely cleared out, and dealers may struggle to hedge
during market-stress events, leading to a rise in VIX futures.
On
Aug. 5, VIX call holders may have struggled to monetize their hedges
given the speed of the market crash and subsequent volatility selloff.
A Bank for International Settlements paper published shortly after
highlighted that a blow-out of bid/offer spreads on out-of-the-money
S&P 500 puts before regular trading hours inflated the VIX spot
level. Since it’s calculated based on the midpoint of the bid/ask, that
level can increase even without trades in S&P 500 options.
Anne Van Kuijk, the head of the S&P 500 and VIX options desk in Amsterdam at Optiver, noted that VIX calls can deliver significantly more convexity than S&P 500 puts in panic scenarios.
And inflows into leveraged short VIX exchange-traded funds have lowered the cost of VIX calls.
VIX and S&P 500 products serve different purposes,
said Jitesh Kumar, a derivatives strategist at Societe Generale SA.
With S&P 500 puts, investors buy options betting on an index level,
while with VIX calls they keep the sensitivity irrespective of the level
— if volatility doesn’t slump. Many market participants also hold VIX
tail-risk hedges for regulatory purposes, serving them “quite well,” he
added.
“Investors need to choose their hedges depending on their spot/vol view,” Kumar concluded.
