Time to look at hedges

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Updated: 21 February 2020

Equities have been in rally mode since the gap lower open on August 26th. Back then everybody was obsessed with the recession story and news headlines were extremely pessimistic. Since then we have seen the S&P 500 rally from 2820 to 3010.
We have had a few more positive economic stats globally lately, but nothing much has changed, except investors’ feelings. The crowd has gone from fearful to optimistic.

VIX, the main risk indicator, has fallen from 24 to 14. That is a huge move lower in risk premium. “Rock bottom” is closer to the 12 level, but given the fact VIX is mean reverting, it should start to offer relatively cheap hedging soon.

VIX Chart

Gold is another “fear” hedge, at least according to some investors. In times of bigger market moves, gold tends to catch bids, just as well as the VIX. Gold can trend over time, while volatility mean reverts, but the chart below shows how VIX and Gold move in tandem when markets get more volatile. Gold showed the first little uptick today. Will VIX follow?

Gold Chart

People often forget the need of hedging when things are looking good, and vice versa, they buy protection when things are volatile. This results in most people actually losing money on hedges (which itself is not a bad thing), but this later reinforces the feeling of “why buy protection again, last time I lost”.

S&P 500 is back to rather delicate resistance levels. Last time it looked like we are about to break up, buying VIX was the most rational trade. Pay close attention to possible reversals in equity indices here. Long VIX protection is not overly expensive here. Other hedge strategies could be constructed by selling out longs and replacing with cheap upside calls in the index.

SPX vs VIX Chart

S&P 500 has managed “confusing” the crowd over past months. Every time the S&P 500 looked like it was breaking up it reversed lower, and vice versa. The index has continued trading stuck in a big range, and bouncing up and down, according to the narrative du jour.
Irrespective if you believe in a break up or not, long volatility strategies are starting to look interesting.

S&P500 Chart