With U.S. market volatility down, protection gets cheap

NEW YORK (Reuters) - A topsy-turvy 2016 start for U.S. stocks has given way to some semblance of order for now, but traders who don’t think the lull in volatility will last may want to use the calm to pick up protection on the cheap, market strategists said.

Traders work on the floor of the New York Stock Exchange (NYSE) February 24, 2016. REUTERS/Brendan McDermid

The cost to protect against a resurgence in volatility is the cheapest it has been since summer last year, by at least one measure, the VVIX index VVIX, a gauge of the volatility of volatility.

“Options on VIX futures are right now attractive as an approach to hedging tail risk,” said Peter Cecchini, chief market strategist at Cantor Fitzgerald.

One way to measure the cost of hedging with VIX options is to look at the VVIX Index. A higher reading for the index translates to more expensive VIX options. Currently, the index is at a five-month low.

That makes the protective trade more affordable.

“We are already starting to see some of the players step in and do that,” said Mark Sebastian, chief investment officer at volatility arbitrage hedge fund Karman Line Capital in Chicago, which currently has a position in VIX options.

The sharp fall in the price of crude, growing concerns about economic growth, and waning confidence in the effectiveness of global central banks’ policies, has hit U.S. stocks hard.

The benchmark S&P 500 index .SPX fell 9 percent in the first 12 trading days of the year, but after recovering somewhat recently, is now down 4 percent in the year to date.

The CBOE volatility index .VIX, or the VIX, which measures investor uncertainty based on the price of S&P 500 options, has lingered well above its long-term average for most of this year. Only this week did the index pull back below the 20 level. On Friday, the index was at 19.30.

The pullback in the VIX has been accompanied by a marked drop in its volatility as measured by the VVIX index.

On Friday, the VVIX touched a low of 82.88, the lowest it has been since early August and well off a high of 121 it touched in late January, when U.S. stocks were in a swoon.

“Generally speaking, a low VVIX is bullish for the market,” said Sebastian.

“Clearly the interpretation is that, at least for now, the foot is off the gas in terms of volatility,” Sebastian, a former market maker on the AMEX and the CBOE exchanges, said.

But the S&P 500 index bouncing back from a two-year low of 1,810 touched on Feb. 11 is no guaranty that the markets are out of the woods. Many still believe there is more pain in store.

Hedge funds and speculators hold the most long bets on VIX futures since late September.

“I still believe we are moving towards recession into the end of this year,” Cecchini said. “Between 1,950 and 2,000 (SPX) I’d be aggressively stepping into hedges.”

The decline in U.S. stocks this year has so far failed to unleash the kind of hedging activity typically seen during big selloffs. Lower volatility is an opportunity for investors to turn to hedging with VIX options again.

Call options on the VIX index closing above 30 and 35 by mid-March are the two most heavily traded VIX options contracts this week, according to options analytics firm Trade Alert data.

Editing by Bernadette Baum