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Are hedges attractively priced here?

Someone wiser than me once said, "buy hedges when they are cheap, not when you need them". Does the current market environment imply that time may be here?

Put skew remains subdued

One measure for the demand of index-level hedges is put skew. The more skew we see, the more likely we're in a reasonably well-hedged market environment.

S&P 500 index options put skew

At present S&P 500 index put skew is quite low, suggesting that the market is not well-hedged, particularly because we see signs of this elsewhere emerging as well.

Implied volatility is near the bottom of its recent range

The VIX has been drifting lower since the October 13th CPI release that brought about one of the most powerful market rallies since the Great Financial Crisis. Following that rally the VIX term structure flipped from backwardation to contango as expectations for market uncertainty in the future exceeded that of the present. A sign that near-term price uncertainty was dropping.

The S&P 500 volatility index (VIX) from 2020 onward

But have we dropped too far, suggesting that some S&P 500 hedges are attractively priced here?

I think that may be the case. Volatility is beginning to become quite cheap from what I can see. At least for the S&P 500's index options.

Realized volatility continues to grind higher

It's one thing if implied and realized are moving in a similar fashion, with a narrow spread between them, if any at all. But what we're seeing right now is that realized volatility is rising as implied falls, with a spread that's large enough to warrant attention.

S&P 500 1-month realized volatility from S&P Global

1-month realized volatility was last measured at 25.74 by S&P Global, vs a VIX at 19.06. If we give dealers any reasonable premium over realized, say two points, then we are looking at a VIX that may be 8.18 points discounted. This also suggests a poorly hedged market environment as combined with low skew, we see that there isn't much demand for hedges against downside risk.

While there are reasons for such as VIX calls and S&P 500 puts not performing well in 2022, these cycles of well hedged → poorly hedged → well hedged markets tend to be self-fulfilling. Whereas when hedges don't work, traders stop using them.

At that point we often see a more fragile market due in part to the lack of hedging, which can lead to fatter tails in either direction, but particularly to the left in the near-term.

MOVE has fallen, but not as much as VIX

The MOVE index, which measures Treasury market volatility, has fallen from its highs. The relationship is showing a reasonably high amount of Treasury market volatility vs the VIX.

The the S&P 500 volatility index is at levels we see near the bottom of 2022's range, but MOVE is quite a bit higher. Often, but not always, credit market volatility tends to bleed into equities.

MOVE (blue) vs VIX (red) via Yahoo Finance

Should we see the bond market, which remains rather illiquid, have more erratic price movements to the downside, we may see MOVE begin to rise again, and in that environment it would have a higher probability of dragging the VIX higher. Particularly because in 2022 there's been a strong negative correlation between rates and equity performance.

10-year note futures liquidity via Chicago Mercantile Exchange

With Treasury issuance having grown from $550B → $700B in Q4 of 2022, and future issuance potentially being upsized due to increasing funding costs due to rising interest rates and the growing potential of some sort of stimulus if there is a recession, it is likely that the Treasury market remains rather illiquid.

The Fed was once the largest bidder, and it has since largely stepped aside. The central bank is only occasionally bidding at longer-dated note and bond auctions as it tempers the pace of the roll-off from its historically large balance sheet during an up to $60B of Treasury market QT per month.

Meanwhile, other previous large buyers like Japan and China have been timid this year, with Japan buying less and China being a net seller of US sovereign debt.

When supply is larger than demand it often leads to more volatility and lower prices (and in this case higher yields). We'll have to see what the rest of this month and the year ahead brings us in that regard. But in the here and now it seems that the correlation is stretched.

Currency volatility remains elevated vs VIX

EURUSD currency volatility is still quite high vs historical norms. Just like volatility in credit markets having the potential to drag equity market volatility higher, currency markets are similar. Particularly with systemically important currency pairs showing market participants persistently concerned about elevated price uncertainty.

EuroCurrency Volatility Index (blue) and VIX (red) via Yahoo FInance

The positive correlation here suggests that there may be some room for VIX to move higher given the other aforementioned factors. Of course a strong Euro rally could bring EVZ lower, but the dollar is reaching close to a rather key support level, so we may see some pressure on the EURUSD pair resume, and that could boost the currency's volatility again.

VIX term structure in contango implies rising volatility

While near-term volatility seems subdued, as we move forward through the VIX futures term structure we can see that the expectation is for volatility to rise going in to 2023. Particularly between the December front month contract and January.

The lack of price uncertainty concerns in the near-term, especially given the discount between implied and realized volatility, suggest that left tail risks may be fattening.

Realized vs implied volatility discount is growing

In the chart below from our friends at Tradewell, we can see that the spread between 1-month implied and historic volatility is widening to close to -8 points.

S&P 500 1-month implied vs realized volatility

That's an extreme that is worth watching based on my analysis of similar periods in the past as it could lead to a higher probability of a negative outcome in the next trading week.

5-day forward returns tend to suffer after VIX-HRV crosses below -7

I looked at about 30 years worth of data to find that only 36% of the time do we see the market close higher over the following five days after seeing this big of a discount between implied and realized S&P 500 volatility.

Scatterplot chart from Tradewell

The one to 60-day forward returns demonstrate greater volatility in either direction, with the maximum run-up at 34.16% and maximum drawdown at -35.49%.

A component of this variability in returns is likely related to how we're often seeing a market under some degree of stress following implied volatility becoming this cheap. Meaning the greatest risk may be in the immediate future when a signal like this is showing up.

Signal summary from Tradewell

What we do know is it increases left tail risks in the immediate future, with drawdowns of up to 14.98% possible in the following 5-day period per historical trends.

5-day probability distribution from Tradewell

When this signal showed up on June 2nd of 2022 we saw a 5-day return of -3.81%. After March 13th of 2020 we saw a -14.98% 5-day return. Following the signal hitting on November 7th, 2018 we saw a -3.99% 5-day return.

After it hit on August 15th of 2011 we saw a -6.7% 5-day return. After it hit on March 23rd of 2009 we saw a -4.3% 5-day return. And finally, after September 30th of 2008 we saw a -14.59% 5-day return.

That doesn't mean downside is guaranteed, though. It just means we have a greater risk of downside, and that that downside could be larger than normal if the market has a reasonably large negative event catalyst.

In conclusion

S&P 500 index hedges may be attractively priced in the form of near-dated SPX put options based on this analysis. It appears we have a higher probability of a negative outcome in the week ahead, particularly if there are any negative event catalysts.

I would not look toward any of this analysis as anything but educational as we have no way to know what comes next in the market. We can only model for probabilities and then put on trades that may fit our own risk tolerance and financial goals. Only do what works best for you!


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