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

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Trading in options tied to the Vix volatility index — popularly known as Wall Street’s “fear gauge” — is on course to hit a record volume this year, as cautious investors look to protect themselves from the risk of a sudden stock market reversal.

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

The Vix shows expectations of volatility in the S&P 500 over the next month, and the bulk of the increase in trading this year has come from investors buying call options — a type of derivative that would pay off if the index spikes higher.

The jump reflects the growing need for investors to hedge their positions amid a fragile stock market rally. The S&P 500 has risen 12 per cent this year, but gains have been concentrated in a few large tech groups and investors continue to grapple with uncertainty around high interest rates and the impact on economic growth.

Charlie McElligott, an equity derivatives strategist at Nomura, said the rally had forced even sceptical investors to increase their exposure to stocks after a sell-off in 2022, but “the fact of the matter is there are still a number of [risks] outstanding”.

“Now that people have equity exposure back . . . and cash coming off the sidelines, you need to hedge again.”

Vix options have been particularly popular because the index has been unusually low for most of the year, increasing the chance of a large payout if it suddenly jumps. The Vix has a long-term average of around 20, but so far in 2023 it has averaged around 17, and dipped as low as 12.7 earlier in September. Last year the average was almost 26. 

“When the Vix is in the mid or low teens, a doubling or even tripling of volatility from there is a lot easier,” said Mandy Xu, Cboe head of derivatives market intelligence. “When it was at 25, doubling that would take a once-in-a-generation type event.”

The growth in Vix trading this year marks a sharp turnaround after several years of anaemic volume growth and increasing questions over the index’s effectiveness and relevance. 

Although the index tends to rise when stocks fall, the correlation is not as strong if markets grind slowly lower as they did in 2022, which disappointed investors who had relied on it as a hedge against a downturn. Meanwhile, an increasing percentage of investor activity is concentrated in extremely short-term options, which are not captured by the main Vix index.

Several firms that used to play important roles in the Vix space have also collapsed since the last time trading volumes were so high. McElligott cautioned that this could make it harder for the banks that sell Vix options to investors to hedge their own positions, leaving them potentially exposed in a crisis.