Asymmetric Risks and VIX

If you watch enough bad television or ancient re-runs (like me), it is inevitable that you will see advertisements for insurance products like Colonial Penn and Car Shield.  Thanks to my decades as an options market maker, I have always paid extra attention to insurance commercials.  In that role, I considered myself to be an insurance underwriter – not for life or auto, of course, but for financial risks.  I bring up the topic today because insurance is most useful for hedging asymmetric risk, and that is exactly what we face today.

Insurance is most necessary when someone faces a low probability, high outcome event.  The odds of one’s house catching fire on a given day is quite low, but it would be a catastrophe if it occurs.   So, we buy fire insurance and hope that the premiums are wasted expenses.  I would assert that the debt ceiling creates a similar type of event.  There may a low probability that a default occurs, but one would be a high outcome catastrophe.  Although the risk of financial arson exists, we’ve also noted that equity investors are generally taking the view that we’ve skirted this risk before so it’s not worth worrying about now. 

But not all investors are completely sanguine.  The significant volume and open interest in upside VIX calls expiring in June tell us that some are buying insurance policies, just in case.  So far this morning, over 150,000 VIX 30 strike calls expiring June 21^st have already traded on a line with over 550,000 open interest. 

Yesterday’s rally reinforced the notion that an agreement may be in sight, which may be why the bulk of the calls mentioned above traded on the bid side.  A holder may have decided that insurance is less necessary today than previously.  Yet the buy-the-rumor, sell-the-news aspect of markets may offer an even greater rationale for hedging now.  For one, it’s cheaper today.  For another, if a greater probability of success gets priced in, it increases the impact of failure.

I was asked recently if VIX was too high or too low.  Quite frankly, if this was a high school debate I could reasonably take either side.  Let us start with a piece of visual evidence:

2-Year Chart: SPX Historical Volatility, 10-Day (yellow), 30-Day (orange); Implied Volatility (white); SPX Level (faint grey)

Source: Interactive Brokers

If we assert that VIX is too high?  If we look at the historical volatility of the S&P 500 Index (SPX) on either a 10-day or 30-day basis, we see that it is quite depressed.  Both are just about 10% on an annualized basis.  That shouldn’t be too much of a surprise; as we noted yesterday, SPX was almost exactly unchanged on a quarter-to-date basis as of Tuesday’s close.  If you believe that we will remain mired in the current trading range, then a VIX level of 16.60 seems high. 

If we assert that VIX is too low?  If you believe that there is a reasonable chance for a stumble along the way to a debt deal, let alone a default, then VIX has plenty of room to run and run quickly.  We have seen a couple of quick spikes on relatively minor downdrafts, as the chart below shows.  On Monday, May 1^st, when VIX touched 15.50, we wrote that markets felt eerily calm.  By Thursday, VIX traded over 21.  When implied volatilities are at relatively low levels, they tend to rise abruptly at even modest signs of trouble.  And as the chart above shows, the last time historical and implied volatilities were this low was the late 2021 – early 2022 period when major indices topped out. 

VIX 20 Day Chart, 15-Minute Bars

Source: Interactive Brokers

Given what I said earlier about the importance of insurance in protecting against low probability, high outcome events, you should be able to figure out which side of the debate I find more appealing.  The latest rhetoric from D.C. has been positive, but a deal remains murky.  When we consider that equity markets have not sold off in response to default fears, it seems reasonable to think that they won’t rally much if an agreement is reached.  In a one-tailed risk scenario, it is often prudent to purchase insurance.  As with your homeowners policy, you may not want the insurance to pay off, but it may help you sleep better at night. 

For further reference about the similarities and differences between conventional insurance and listed options, please read this piece from August 2021:  Moral Hazard, Insurance, and Options | Traders’ Insight (ibkrcampus.com)