Index vol has been a poor hedge for equity rout, traders say

Single stock ‘micro’ hedges have offered more protection in this year’s selloff

Traditional long volatility hedges have offered little protection during the recent selloff in US equities, traders say, as the growth-to-value rotation left index volatility unusually subdued in the face of a sharp drop in stock prices.  

Hedging equity risk by buying calls on the Vix index of S&P 500 options volatility has proved “quite difficult,” said Marc Möhrle, a portfolio manager at DWS, “because index vol just didn’t pick up at all or is quite depressed even though we’ve had quite strong spot moves”.   

“Over the last couple of days, we’ve had situations of spot down, vol down, which is completely odd,” he added.  

Möhrle was speaking on a panel at the Eurex Derivatives Forum in Frankfurt earlier today (May 24).  

The S&P 500 has shed nearly 18% since the start of the year, while the Vix is currently hovering around 29, down from a peak of 36.45 on March 7. The typically inverse correlation between the Vix and S&P 500 has reversed on a number of occasions, including on May 19, when the S&P 500 closed down 0.5% while the Vix fell 1.5 percentage points. 

“Volatility was probably not the best way to hedge the beta component of your portfolio” on that day, Möhrle said. 

Financial markets have endured a volatile start to the year as central banks raise interest rates and shrink their balance sheets to battle soaring inflation.

We’re actually seeing a lot more dispersion and volatility on names rather than in the headline indices at the moment

Pavlos Syrimis, Goldman Sachs

A post-pandemic return-to-work trend coupled with ongoing supply chain disruptions and the war in Ukraine have driven an unprecedented rotation away from high-growth tech stocks to commodities and defensive sectors, such as utilities and healthcare.   

“The big story of the last few months has been this great rotation between value and growth, commodity sectors and defensive and the more speculative stuff,” said Hugo Bernaldo de Quiros, senior cross-asset trader at Optiver, speaking on the same panel.  

“This is one of the large reasons why these equity index hedges haven’t really worked that well, because all of those implied correlations have not picked up so much. There’s been all this big reshuffling between different components of indexes, so it becomes very important to know what kind of vol you hold,” he added.  

Pavlos Syrimis, head of single-stock volatility trading at Goldman Sachs, said “micro volatility” in individual names offered better protection in the current conditions, and may continue to do so.  

“We’re actually seeing a lot more dispersion and volatility on names rather than in the headline indices at the moment and we think this can continue to be the case,” said Syrimis, speaking earlier at the event. “All of the cross-asset factors that we’re seeing mean we’re likely to see heightened micro volatility for some time to come.” 

He gave the example of Swiss conglomerate Nestlé, traditionally one of the most stable stocks in Europe, which now trades with a higher realised volatility than the Euro Stoxx 50 benchmark.  

“That doesn’t normally happen in market selloffs and it’s really because of the duration nature of the way people think about that stock,” said Syrimis. “I think that’s part of the reason why you want to be owning micro volatility in the short term.”  

When it comes to macro index hedges, Optiver’s Bernaldo de Quiros argued that not all benchmarks are created equal. FTSE 100 index volatility, for instance, has been a poor hedge for cross-asset portfolios due to the international nature of its components.  

“The FTSE is made of all these international companies that have US dollar revenues. It’s priced in pounds and the pound has been selling off, so it’s been pretty much flat for the year. It has a lot of these dividend paying companies, or commodity producers which have been outperforming the market,” said Bernaldo de Quiros. 

The UK benchmark is down just 0.28% year-to-date, as of May 24. “If you own FTSE vol to hedge your portfolio, cross-asset, you didn’t do too well,” he said.  

Other indexes such as the Nasdaq or Dax, which are more heavily exposed to supply chain disruption and commodity price inflation via autos and other industrials, have been a far more effective hedge, Bernaldo de Quiros said.  

Realised volatility will just go up, because you will just see more and more swings in the market

Tobias Hekster, True Partner Capital

The Nasdaq is down 29% so far this year, while Cboe’s Nasdaq Volatility Index closed at 37.58 on May 24, up from 21 at the start of the year. Germany’s blue-chip Dax index is down 13%, while the VDax volatility index is trading at around 26.2, down from a high of 45 in early March.  

Bernaldo de Quiros highlighted the need to consider index dispersion when placing hedges. “It has implications of all sorts and you need to think a little bit harder and not just rely on the data from the past five or 10 years,” he said.   

Möhrle added that long gamma hedges have worked better in the eurozone due to the heavy impact of Russia’s invasion of Ukraine at the end of February.  

“We had this quite fast selloff there [in Europe] and the recovery, so you had the situation or the opportunity to profit in both ways,” he said.   

Tobias Hekster, co-chief investment officer at True Partner Capital, argued index volatility could continue to rise as central banks double down on their core aim of taming inflation. “I personally believe that realised volatility will just go up, because you will just see more and more swings in the market to the downside as well as to the upside,” said Hekster.  

He predicted the Vix would hit 40 by year end. Asked for his view, Möhrle said the increase would be smaller, at 35.  

The panellists also predicted that Tesla would be trading well below its current $635 stock price by year-end – as low as $300 according to Bernaldo de Quiros. The stock is already down nearly 50% since hitting its all-time high of over $1,200 last November.