As Stocks Reach New Highs, Investors Abandon Hedges With volatility at consistently low levels, more are revising their strategies A trader monitors prices in the Cboe Volatility Index pit at the Cboe Options Exchange. The VIX, which tends to move in the opposite direction of stocks, closed below 10 more times last year than any others year in its history. Photo: Scott Olson/Getty Images By Gunjan Banerji Updated Jan. 8, 2018 7:19 p.m. ET 27 COMMENTS Big stock-market gains are leading a number of investors to abandon defensive positions taken to protect against a market downturn, the latest sign that many doubters are shedding caution as the long rally rolls on. Investors with significant positions in stocks often look to offset that risk by buying put options on stocks or major stock indexes, like the S&P 500. These contracts are a form of insurance that pay out when stocks fall. But with the Dow Jones Industrial Average breaking through 25000 for the first time, the Nasdaq Composite crossing 7,000 and with market volatility falling to near all-time lows, many investors have decided that spending money to hedge against big declines is a waste of money. While the Dow Industrials slipped 0.05% Monday, the S&P 500 and Nasdaq Composite closed again at records. Stock pickers are already feeling squeezed by competition from lower-cost passive investments such as exchange-traded funds and worry that they can’t risk falling behind in a rally. Purchasing market protection through hedges eats into their returns. “I haven’t seen hedging activity this light since the end of the financial crisis,” said Peter Cecchini, a New York-based chief market strategist at Cantor Fitzgerald. “It started in late 2016 and accelerated in the second half of the year.” VIX PlungeThe Cboe Volatility Index, or VIX, just recorded its lowest yearly average in history.Source: FactSet Average VIX1990’92’94’96’982000’02’04’06’08’10’12’14’1605101520253035 Others signs of skeptical investors acknowledging the pull of the powerful bull market have also cropped up in recent days. Jeremy Grantham, a bearish investor at Boston money managers Grantham Mayo Van Otterloo & Co. with a history of spotting market tops, said last week that investors ought to brace for explosive short-term stock gains. He dubbed this phase a “melt-up,” or climactic late-rally leg higher that might push prices up an additional 50% over the next six months to two years. A University of Michigan survey in October showed that consumers saw a nearly 65% chance on average that the stock market would rise in the next 12 months, the highest share on record. That measure remained near record levels in the following months. New data indicate that either demand for protection is low or investors are favoring bullish options on the S&P 500 instead. A measure called “skew,” gauging the cost of insuring against short-term stock declines, recently hit a one-year low, data from Credit Suisse Group AG show. Related S&P 500 Extends Record Run Bets by hedge funds against volatility—similar to a bullish wager on stocks—outnumber bets on rising volatility, recent Commodity Futures Trading Commission data show. At 12 of the biggest banks in the world, revenue in their equity-derivatives businesses that focus on listed options shrank during the first half of 2017. The blue-chip gauge has gone 386 trading days without a selloff of 5%, its longest stretch since 1996, according to The Wall Street Journal’s Market Data Group. By letting their hedges expire, investors would feel the full brunt of a market selloff. While that would intensify the pain for any individual trader, some analysts and brokers worry that the cumulative effect of more investors giving up their protective positions could itself become a source of volatility. Many investors could rush to sell their positions and limit their losses during the next period of market weakness, exacerbating any plunge in prices. “When the ultimate disruption occurs, the market is less prepared for it,” Dean Curnutt, chief executive at New York brokerage Macro Risk Advisors, said. “That becomes an amplifier of the risk.” Related Video Dow Hits 25000: Here's Why It Matters The Dow Jones Industrial Average crossed 25000, marking the latest big-number milestone for the index. So why does it matter? WSJ Markets Reporter Akane Otani explains. Photo: Reuters Howard Marella, founder of broker Icon Alternatives, had been a regular buyer of put options on individual stocks and indexes to protect his portfolio. Heading into last year, he changed his mind. Persistently low interest rates and the big stock market rally that followed the presidential election prompted him to abandon most of the options that had shielded him against drops in share prices. Now, he views a market decline as an opportunity to buy cheaply, rather than spending his cash to hedge against it. That strategy paid off handsomely in 2017, when major stock-market indexes repeatedly rose to records. “Buying dips is still going to be the way to go,” Mr. Marella said. Hedging against an unexpected surge in market turbulence, meanwhile, was a money loser. The S&P 500 jumped 19% in 2017, and the Cboe Volatility Index, known as the VIX, had its quietest year in history. That meant investors who bought such options were often stuck with worthless contracts. It was “a really difficult year to be a hedger,” said Macro Risk Advisors’ Mr. Curnutt. It wasn’t supposed to be this way. Heading into 2017, many investors and analysts anticipated a new regime of market volatility with the Federal Reserve accelerating its pace of interest-rate increases and signaling an end to the era of supereasy monetary policy that followed the 2008 financial crisis. A wave of political uncertainty linked to U.S. tensions with North Korea and the new presidential administration also raised the prospect that market tumults could occur with greater frequency. Instead, a calm not seen in decades permeated markets. One sign of that: the VIX, which tends to move in the opposite direction of stocks, closed below 10 more times last year than any others year in its history. OutlierThe Cboe Volatility Index, or VIX, closed below 10 more times in 2017 than at any other time in historycombined.Source: FactSet 00000000000000000000000Sum of VIX ClosesUnder 101990’92’94’96’982000’02’04’06’08’10’12’14’160510152025303540455055 Minor spikes in the VIX did crop up, but the gauge remained entrenched below its historical average throughout 2017. “The first four Fed hikes in a decade have failed to generate the revival of volatilities that many had expected at the end of last year,” wrote Marko Kolanovic, a quantitative and derivatives analyst at JPMorgan Chase & Co., in a December note. Placid markets could continue into 2018, Bank of America Merrill Lynch wrote in a recent report. “The behavior of volatility has entirely changed since 2014,” because major central banks have kept interest rates near historic lows, analysts wrote. It suggested that the VIX would be hard-pressed to return to its long-term average of 20 “in a low rates world.
Interesting post, thx The main problem with financial assets is that this is not the "fashion week". So you have zero interest to anticipate next mood / cycle, being contrarian / different. Because you will be broke then, fighting against the trend. Patience is key here. Finally, when (insidiously) fear will be back... go for the jugular ! CM