Fed Optimism Spurs Record Bets Against Stock VolatilityInyoung Hwang
A soft touch on monetary policy will continue to suppress stock volatility, or so suggests the record stretch of cash going into an exchange-traded note that rallies as calm returns to equities.
The Chicago Board Options Exchange Volatility Index, known as the VIX, has decreased 31 percent this month and investors are wagering on further declines. In the five weeks through Aug. 15, they put almost $320 million into the VelocityShares Daily Inverse VIX Short Term ETN -- the longest stretch of weekly investments since the note began trading in 2010.
Bets against volatility show traders are conditioned to expect turmoil in the stock market to be brief. The VIX surged as much as 64 percent in July as shares slid for the first time in six months. Investors were quick to speculate the volatility index would fall back, as it has since 2012, Ramon Verastegui of Societe Generale SA said.
“Central bank accommodative policies tend to limit tail risks and therefore to prevent big market drawdowns and very high volatility spikes,” Verastegui, the head of engineering and strategy at Societe Generale in New York, said by phone. “Given this ‘artificial cap’ on volatility, periods of correction are generally a good window to sell volatility.”
Federal Reserve officials raised the possibility they might raise rates sooner than anticipated, as they neared agreement on an exit strategy, according to minutes of their July meeting released yesterday. Fed Chair Janet Yellen has committed to use monetary policy to strengthen the labor market so long as inflation remains in check.
Ways to speculate on how noisy or calm the stock market will be have exploded in the last decade with the advent of exchange-traded notes tied to the VIX. Strategies include relatively simple hedges against equity losses, such as owning a security that mimics the volatility gauge. The most popular of those, the iPath S&P 500 VIX Short-Term Futures ETN, saw almost 40 million shares change hands yesterday and ranks among the most-heavily traded securities of any variety in the U.S.
A more complex instrument is VelocityShares’s XIV note, which as its ticker symbol implies, moves in the opposite direction of the VIX. The ETN, with volume of 10 million shares yesterday, represents a bet that is similar to owning stocks. After losing 12 percent in July as the Standard & Poor’s 500 Index slipped 1.5 percent, both have rebounded in August, and shares outstanding of XIV have surged 33 percent this month, data compiled by Bloomberg show.
The XIV note declined 0.8 percent to $44.03 yesterday as the S&P 500 rose 0.3 percent to 1,986.51, within two points of its July 24 record.
The VIX slipped 0.9 percent to 11.67 at 11:07 a.m. in New York today, after ending 39 percent below its five-year average yesterday. It rallied last month the most since 2011 after a Malaysia Airlines passenger jet crashed in Ukraine and concern grew about Portuguese bank debt.
“We’ve had turmoil in the Ukraine, Syria, Iraq, and the West Bank, we’ve seen the impact of sanctions on Russia,” Arthur Lu, director of equity-trading strategy at Citigroup Inc. in New York, said by phone. “U.S. investors have taken hits and been mostly resilient to them.”
Investors have also boosted bets against the biggest volatility exchange-traded product. Short interest on the iPath short-term futures note has jumped to 60 percent of shares outstanding from 19 percent in May, data compiled by research-firm Markit show.
The last time investors poured large amounts of money into the XIV was in the first week of February, when they added $213 million, data compiled by Bloomberg show. Their bets proved right. While a rout in emerging-market currencies spurred a jump in volatility during January, the S&P 500 resumed gains, rallying for five straight months through June and reaching an all-time high of 1,987.98 on July 24.
The benchmark equity gauge has almost tripled since March 2009 amid three rounds of bond buying from the Fed. It hasn’t experienced a correction of 10 percent or more since 2011. The measure is now trading at 16.6 times estimated earnings, 16 percent higher than its five-year average of 14.3, according to data compiled by Bloomberg.
The reasons investors are adding money to XIV and shorting VXX are not always obvious because the notes are sometimes used in conjunction with other securities, according to Jon Cherry of TJM Institutional Services LLC.
“What could be driving them is that the market has been resilient for many years,” said Cherry, senior vice president of derivatives trading at Chicago-based TJM. “I do feel as though we should be seeing volatility rise with tapering and geopolitical issues.”
While the VIX is below its historical average, the threat of inflation is still low, making it less likely that the Fed will raise interest rates soon, according to Rex Macey of Wilmington Trust Investment Advisors Inc. in Atlanta.
“You have to worry about complacency,” Macey said. His firm oversees $82 billion. “You feel much more comfortable in markets when everyone’s worried, but it’s been a Fed-induced calm. It’s a calming of markets and giving people a sense of security.”