Fears of “Busted” VIX Overblown

Prominent volatility gauge still measures what it should, with help from the Credit Suisse Fear Barometer.

Since its recalibration in 2003, the VIX or CBOE Volatility Index, has offered investors a gauge of expected market volatility that many have boiled down to two simple rules of thumb: 

When the market sags, the VIX should jump. 

When the market rallies, the VIX should drop. 

However, when the VIX doesn’t stick to that script, as happened during market turbulence in 2022 and into early 2023, market participants cry that the VIX is “broken,” which echoes across Wall Street and beyond. 

Yet, oversimplification can be as dangerous as over thinking when it comes to hedging the market. While we actively monitor and use the VIX (no, it’s not broken) in our liquid derivative strategies, we gauge what it’s telling us in tandem with the Credit Suisse Fear Barometer (CSFB).   

Ultimately, we believe this approach will provide a much better hedge against market volatility over the long haul.

Options Trends at the VIX’s Foundation

A quick recap on how the VIX works.  

When investors are nervous about the market, they buy protection in the form of puts. When they’re feeling optimistic, they buy calls. 

As the CBOE explains in a freely available white paper, the VIX is calculated by aggregating the weighted prices of puts and calls on the S&P 500 Index over a wide range of strike prices. 

And yes, for most of the time when the market sinks, the VIX jumps. And when stocks rally, the VIX fades. 

Those aren’t universal occurrences, however, most investors understand this price movement, but few know how it is calculated. 

Therefore, we’ve heard continued mumblings since late 2022 that the VIX is broken. Just like we did in February 2021, May 2017, and an assortment of other times when market dynamics (and the calculations behind the VIX) didn’t fall in line behind the simple rules of thumb above. 

It’s gotten bad enough at times that some have administered last rites to the VIX. 

It’s All Relative

To be clear: The VIX is not broken. Nor is it dead. 

It is still an amazing instrument that’s used to give you a predictive look into where people believe the broader stock market is heading. 

But it’s not the same in every market environment. The hedge you’re going to use when the VIX is at 40 is going to be dramatically different than the hedge you’re going to use when the VIX is at 12.  

And if you had done the math in 2022, you would have seen that it was unlikely the VIX would not expand in the market selloff.  

And still, a lot of strategies out there worked from the assumption that if the market were to go lower, the VIX would go higher. So, they went and bought call options on the VIX and financed those tactics by selling put options on the equity market.  

When the market went down, the put options cost them money and the VIX never went up because nobody needed to buy the VIX. A lot of the players, who had previously been short VIX calls, had exited the market, thus those call options on the VIX never appreciated. 

Fear Barometer Adds Valuable Context

While we still stand by the VIX, we don’t see it as a standalone datapoint. 

To sharpen its predictive capabilities, we contend one must also examine the Credit Suisse Fear Barometer which was developed in part by our co-founder Dennis Davitt in 2008. The CSFB is a second derivative of the VIX as it measures the steepness of the volatility curve by gauging market demand for put options versus the market demand for call options. 

Picture a seesaw with one end on the ground and the other up in the air. As you move along the seesaw, you get either higher or lower, which reflects the difference between the market’s potential upside and downside—also known as skew. 

The skew grows sharper as either market demand for puts rises or market demand for calls declines. 

In late 2022, that seesaw flattened out considerably, reflecting limited skew as most of the inputs into the VIX were the same height. The puts and calls traded in a relatively tight range despite the market’s broader downturn.  

Conversely, during the market’s September 2023 retreat, the CSFB reflected a more reasonable skew and the VIX did expand as the market sold off. 

Given that action, we’re waiting for the headlines that the VIX is healed. 

Trading the VIX/CSFB Teeter Totter 

Regardless the broader market expectations, we regularly take our derivative analysis to where the current market is, as opposed to waiting for the market to come to us.  

It helps to track back to the basics of being a floor trader. When you’re buying and selling options all day long, you must be precise on where you are on the volatility curve, which, like the yield curve for fixed-income trading, has points that are cheaper and points that are more expensive relative to each other. 

At the same time, we know derivative traders have a history of trading too much, which can erode investor returns. We, instead, limit our trading to once a month, rolling the portfolio 100% into what we think is the most efficient hedge relative to market conditions. 

We sit down with our investors and show them the trading bands, and if the fear barometer is “here” and the VIX is “here,” we should be doing “this” trade. 

Ultimately, big market dislocations can undermine our strategy, but when you design a portfolio that you think fits fit every potential scenario, you’re still going to miss the outliers. There’s a reason they’re called third or fourth standard deviations. 

Such disconnects do not stem from a well-established market gauge being on its last legs. 

The VIX reflects the specific pieces of data the options market gives it. If you hear someone exclaim that it’s broken, take a look at the skew reflected in the CSFB.

At MDP, we provide a liquid, direct investment vehicle for investors looking to achieve equity-like returns with additional downside protection.

We do not consider ourselves to be an overlay strategy, and unlike high-yield bond funds or alternative assets which can lack liquidity when it is needed the most, our fund exclusively consists of highly-liquid S&P 500 options and ETFs. Our proprietary four-quadrant strategy, which adjusts to the current volatility regime as reflected by the VIX and the skew, provides growth and stability, allowing investors anticipating volatility events to maintain a balanced diet and comfortably remain invested in the market.

To explore how your portfolio may benefit from efficient and liquid hedging strategies, contact MDP CIO/CEO Dennis Davitt today at 828-499-7223.