Is The VIX/SPX Marriage Heading For The Splits?

“VIX, you got some ‘splainin to do. I am hearing and seeing a lot of ‘what the heck is going on with the VIX and VIX-leveraged ETFs in social media lately. What I am not seeing is a lot recognition for prudent institutional investing that has found this investor class taking advantage of deploying their hedging strategies with what would be the most optimal way to do so, via SPX options.

I say that tongue in cheek as this isn’t a new phenomenon, but it’s certainly an inexpensive way to do so given how cheap volatility has become.

In recent years and even more recent months, hedging via volatility has actually gone out of favor, seeing how the VIX committed to a great deal of down trending from 2016 into 2018.  Largely, hedging by going long volatility and via .SPX options proved little more than a tax on asset manager’s long portfolio.  In 2017, the mean VIX reading was 11.10; it’s lowest ever annual mean average, pretty cool huh? Where were you when volatility got crushed through 2017?  Well I know where I was. I was warning some of the institutional crowd that this wouldn’t prove an advantageous hedging strategy, writing covered calls or going long volatility.  And it wasn’t a good hedging strategy as 2017 also found the VIX achieving a new all-time low reading below 9 percent and doing so without any significant and sustaining upward mean retracing. 

Here in 2018, there has been some strangeness, they would say, in the volatility complex.  This strangeness is characterized by the S&P 500 (SPX) achieving daily record high levels…but with the VIX also rising in tandem.  Strange huh?  Well, not entirely if we accept the reality that is; the VIX has a negative 80% correlation with the S&P 500.  So, when the S&P 500 falls, the VIX usually rises.  After all, the VIX is priced from a portfolio of S&P 500 options and the futures price from the market’s expectation of where the VIX Index will settle at expiration (IV).

Institutional investors tend to buy put options to hedge their portfolios when the S&P 500 falls, thus driving up the cost of premiums leading to a higher level of the VIX.  But then there is that 20% of the time that the SPX magnetizes to the VIX whereby both move down together or up together. Furthermore, again it would be warranted to recognize the prudent deployment of institutional hedging strategies that is clearly at play in 2018.  The S&P 500 has seen a record number of trading days without a 5% pullback.  In the minds of asset managers, this is a bit scary to accept and especially with records being set by the major averages daily, record S&P 500 RSI and bond yields starting to signal inflation ahead. The psychology suggests that deploying hedging strategies is necessary, especially with volatility being so darn cheap.