Perfect Volatility Storm Brewing

The Cboe Volatility Index (VIX) spiked to its highest level in nearly half a year on Wednesday, reflecting a trifecta of investor worries: next week’s U.S. elections, a lack of fresh relief measures and a third wave of coronavirus cases around the world.

While the VIX fell back to 38 today, market volatility is alive and well.

The $1.2 billion iPath Series B S&P 500 VIX Short Term Futures ETN (VXX), which tracks VIX futures, is now up 83.4% for the year, while the $1.4 billion ProShares Ultra VIX Short-Term Futures ETF (UVXY), which leverages its VIX futures exposure by 1.5x, is up 79.5% in the same period.

YTD Returns For VXX & UVXY

Even as U.S. stocks hit record highs in August and September, the VIX remained elevated as investors refused to abandon their hedges ahead of a potentially turbulent fourth quarter that holds a presidential election. The S&P 500 notched multiple new highs during those months, but the VIX never fell below 20—a phenomenon that hasn’t occurred in two decades.

Since putting in its last high on Sept. 2, the S&P 500 sold off almost 9%, while the VIX has doubled to 40. That’s about three or four times what the volatility index trades at during placid times, though it’s still half of what it was in March, when the VIX closed at a record 82.69.

Cboe Volatility Index (VIX)

Explaining The VIX

The VIX measures implied volatility, a figure based on the price of near-term S&P 500 Index options. When stocks gyrate wildly, options contracts—which allow investors to buy or sell at predetermined prices—tend to cost more.

In addition to being a thermometer of investor sentiment, the VIX is used by investors and traders as a tool for hedging and speculation. There are no products that precisely track movements in the VIX itself (spot VIX) because the portfolio of options that the index tracks is constantly changing.

VIX futures and exchange-traded products that track VIX futures—like the aforementioned VXX and UVXY—are the next best thing. They tend to have a pretty tight correlation with spot VIX over short time periods, while that correlation breaks down over longer time periods due to the structure of futures markets, which require the “rolling” of contracts from month to month that eats away at returns.

Strong Hedging Demand

The VIX usually rises when stocks fall, and vice versa. That’s why it has a reputation as Wall Street’s “fear gauge.” But this year, the normal correlation has broken down, as the VIX has stayed high throughout both up and down markets.

The most likely explanation for this phenomenon is the strong demand for hedging by investors who don’t want to be blindsided by an unexpected election outcome or another COVID-related hit to the economy.

This week, all that hedging proved prescient as stocks tumbled the most since March amid rising coronavirus cases worldwide. Concerns that more virus relief measures may not come until next year added to the downbeat mood on Wall Street.

Other Hedges

A look at the VIX futures curve suggests that volatility traders think that the peak of uncertainty is right now. The futures curve slopes downward throughout the rest of the year and into next year (a condition known as backwardation), though implied volatility remains stubbornly high for many months into the future. 

Other instruments investors use for hedging, like gold and Treasuries, are also elevated, though off their recent highs. Spot gold prices were last trading close to $1,900/oz, down from the record $2,064 seen in August, but still in rarified air. The SPDR Gold Trust (GLD) was last trading with a 23.3% year-to-date return.

At the same time, the 10-year Treasury bond yield was last trading at 0.79%, down from 1.92% at the start of the year. The yield may be near the upper end of its range of the past seven months, but it is still at historical lows. The iShares 7-10 Year Treasury Bond ETF (IEF) was last trading with a 10.7% year-to-date gain (bond prices and yields move inversely).

YTD Returns For GLD & IEF

Finally, defined outcome ETFs, which use options to limit downside equity exposure at the expense of some upside potential, have largely followed the broader markets recently. However, they promise to shield investors from a bigger sell-off were one to occur.

The $74 million Innovator S&P 500 Buffer ETF – October (BOCT) has fallen about 2% month-to-date, similar to the S&P 500. But if the markets keep dropping, the fund aims to limit downside to 9% over the one-year outcome period. For that benefit, investors are capped at 18.3% return on the upside. (Read: “How Defined Outcome ETFs Work.”)

Email Sumit Roy at [email protected] or follow him on Twitter @sumitroy2