A market hedge traders use if volatility spikes and the sell-off gets worse
The Cboe Volatility Index (known as the “VIX”) measures the market’s expectation of volatility over the next 30 days as implied by a weighted strip of S & P 500 Index options. When investors are nervous, options premiums, and therefore the VIX tends to spike, reflecting heightened uncertainty. A very high reading often signals panic or extreme fear. Such spikes sometimes suggest that the market may have overreacted, potentially offering buying opportunities. The problem with using the VIX alone as a buy or a sell signal is that while sometimes fears are overblown, sometimes they’re not. For example, during the so-called “Taper Tantrum” in 2018, in the first 10 days of October the S & P 500 fell more than 6.7% while the VIX more than doubled from ~12 to ~25. . However, that did not prove to be an exceptional buying opportunity, the S & P lost almost another 14% through the lows that December. .VIX 5Y mountain Cboe Volatility Index, 5 years A VIX level in the 20s suggests the market is fearful but does not indicate panic. The VIX around 22 is approximately the 72nd percentile — above average but not extreme. So what constitutes extreme? To give VIX levels some context, I broke it into deciles. In the chart below, along the x-axis are the respective deciles. 0-10 is the lowest decile – the bucket with the lowest 10% of all VIX observations and 90-100 is the top decile, the highest 10% of all VIX observations. The columns represent the average return over the subsequent 30 days. So when the market is extremely complacent, the bottom decile, the average 30 day return looking forward is .72%. The second decile average return is .8% and so on. As of Wednesday’s close, the VIX was at the 71.5%ile for all data, the decile represented by 70-80 along the x-axis in the chart. As you can see, the average return for the S & P 500 over the subsequent 30 days is anemic .07%, and well below the 30-day average return for all data of .81% (the straight blue line). That “bucket” represents VIX levels between 21.59 and 24.28. Does that mean the market will have below-average returns over the next 30 days? Not necessarily, but it’s a dangerous area when considering a couple of other factors. One issue is valuation. While valuation is not a market timing tool, well-above-average valuations present additional risk. The S & P 500 is trading at a 25-30% premium to the average forward earnings multiple over the past 35 years. Second, the VIX is trading at a ~25% premium to the average over the past 30 days. Why does this matter? Volatility is a mean-reverting process, that is, it is much higher than the average of the past month suggests it is currently moving away from the mean, whereas if the prior 30 day average VIX level was higher than the current level it would indicate it is moving back towards the mean. Incorporating those additional factors where the current VIX level is above the rolling 30-day average, and the forward PE is above 18, the average returns over the subsequent 30 days is -.73% This type of data analysis can be sketchy because the more filters one imposes, the sparser the dataset becomes. In 35 years, only 219 trading days, or 2.47% of the data, meet these criteria. The trade If you’re concerned that the rising VIX is a sign that things could get worse before they get better, a hedge might help you avoid the panic, if that’s what’s coming. Using SPDR S & P 500 ETF Trust (SPY) as a portfolio proxy, one could construct a “zero-cost put spread collar.” This collar is so named because the objective is that the premium collected from selling an out-of-the-money put and an out-of-the-money call will offset the cost of purchasing a closer-to-at-the-money put. Below, I’ve provided an example using May options (as/of Wednesday’s closing prices). Buy SPY May 16 $565 put Sell SPY May 16 $610 call Sell SPY May 16 $520 put DISCLOSURES: (None) All opinions expressed by the CNBC Pro contributors are solely their opinions and do not reflect the opinions of CNBC, NBC UNIVERSAL, their parent company or affiliates, and may have been previously disseminated by them on television, radio, internet or another medium. THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.
