In our latest research article “Market Complacency Ruling The Day Into U.S. Election” we highlighted that complacency in the stock market, as measured by the VIX Volatility Index (INDEXCBOE:VIX), is at levels rarely seen.
On its own this is not breaking news, but it is very strange when contrasted with the palpable concerns over the coming presidential election. In additions, we have more general market risks such as weak economic growth, extreme stock market valuations, corporate earnings recession and various geopolitical worries. We ended that article discussing the employment of equity insurance. And further, how insurance is relatively cheap in the context of a riskier profile for equities markets.
The VIX is an equities volatility index that uses put and call option pricing to calculate an implied level of future volatility. Upon researching specific VIX “insurance” strategies, we noticed something that caught our attention and further strengthens the case for adding VIX exposure.
All futures and commodities exchanges release data on contract volumes and positioning. As one can see in the graph below, net speculative positions in the VIX futures contracts are at record levels of short exposure. In other words, speculators betting on a VIX decline outnumber those betting on an increase in volatility by the largest margin in at least twelve years (i.e. there are a lot of VIX shorts). A normalization of this positioning could quickly occur and in a disorderly fashion due to the extreme positioning of speculative traders leaning on VIX shorts. If this were to occur it would likely add to downside pressure on stock market prices.
To be fair, irrational can stay irrational longer than investors think. But we investing is a probability business and this is something to keep an eye on in our opinion.
The current low level of implied volatility may be justified, and the political and economic environment that concern us may turn out to be benign. However, given the potential for market damaging events, the historically low price of insurance, the limited downside of the VIX and the massive net short VIX positions, we think it’s a good time to get some cheap insurance to protect equity investments against downside risk.
Thanks for reading.
Twitter: @michaellebowitz
Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of any other person or entity.
