In the stock market, it looks like an ideal time to be the insured rather than the insurer.
Equities have been extremely volatile since October, as investors have panicked about a potential U.S. recession, trade tensions and a slowing global economy. This has led to a jump in the Cboe Volatility Index or VIX, known as Wall Street’s “fear gauge” because it tracks the expected daily swings in the S&P 500 index over the next 30 days using options contracts.
Yet the VIX still doesn’t look as elevated as it should be. After recently spiking to above 35, it’s back below 20. This may look high, but it’s significantly below where the actual volatility of the S&P 500 has been during the past 30 days.
Situations like these are rare windows of opportunity, because options prices tend to overestimate future realized volatility. It’s like the insurance industry: Over time, most people who insure their house pay more in premiums than they get in return—ignoring peace of mind—whereas insurers tend to make a profit, even if sometimes they need to pay out a lot.
Sure, the VIX may be simply assuming that realized volatility is so unusually elevated—currently at its highest since 2015—that it will come down. But that isn’t the assumption baked into futures contracts that allow investors to buy or sell the VIX. These remain more expensive for short maturities than longer ones, suggesting markets expect more near-term swings even as stocks have been recovering.
With no real sign of a U.S. recession and valuations now more attractive, the new-year calm in markets might continue. But options currently offer an attractive way for investors to acquire cheap protection in case it doesn’t. Before fourth-quarter reporting season kicks off next week, providing clarity on corporate earnings, insuring for more bumps seems like a good idea.
Write to Jon Sindreu at firstname.lastname@example.org