Trade in ‘fear gauge’ at high as investors hedge amid fragile markets

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Options trading tied to the Vix Volatility Index, commonly known as Wall Street’s “fear gauge,” is expected to reach record highs this year as cautious investors look to protect themselves from the risk of a sudden reversal in the stock market.

So far this year, investors have traded an average of 742,000 Vix-related options per day, up more than 40% annually and above the full-year record of 723,000 set in 2017, according to exchange operator Cboe.

Vix shows expectations for moves in the S&P 500 over the next month, with much of this year’s volume growth coming from investors buying call options – a type of derivative that can pay off if the index surges.

The gains reflect growing demand from investors for hedging positions amid a fragile stock market rebound. The S&P 500 is up 12% this year, but the gains have been concentrated in a handful of large technology groups as investors continue to grapple with uncertainty about high interest rates and their impact on economic growth.

Charlie McElligott, equity derivatives strategist at Nomura, said the rally in stocks after the sell-off in 2022 has forced even skeptical investors to increase their exposure to equities, but “the reality is that “Yes, there are still many unresolved (risks).”

“Now that people are regaining equity positions . . . and cash is flowing out of the sidelines, you need to hedge again.”

Vix options are particularly popular because the index is unusually low for much of the year, increasing the chance of a huge payout if it suddenly rises. The long-term average for the Vix is around 20, but so far in 2023, the average has been around 17, falling to 12.7 in early September. Last year the average was closer to 26.

“It’s much easier to double or even triple volatility when the Vix is in the mid-teens,” said Mandy Xu, head of derivatives market intelligence at Cboe. “By 25 By that time, doubling would require a once-in-a-generation event.”

This year’s growth in Vix trading marks a sharp turnaround after several years of lackluster volume growth and growing questions about the index’s validity and relevance.

While the index tends to rise when stocks fall, the correlation won’t be as strong if the market slowly moves lower as it did in 2022, disappointing investors who rely on the index as a hedge against an economic downturn. At the same time, more and more investor activity is focused on very short-term options that are not covered by the major Vix indexes.

Since the last time trading volumes were this high, several companies that were once major players in the Vix space have also collapsed. McElligott warned that this could make it more difficult for banks selling Vix options to investors to hedge their positions and could face a crisis.

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