Volatility Vanishing Act? Hedge Funds Double Down on VIX Shorts

Is the era of high market volatility over? Hedge funds seem to think so, as they are shorting the VIX volatility index at a pace not seen in three years. This massive bet on low volatility raises concerns about whether the current calm is just a mirage before an impending storm.

Data from the U.S. Commodity Futures Trading Commission (CFTC) shows that hedge funds and large speculators held a net short position of approximately 92,786 contracts linked to the VIX as of August 19th. This is the highest level since September 2022, indicating strong conviction in continued market tranquility.

Analyzing Hedge Fund Motivations

Chris Murphy, co-head of derivatives strategy at Susquehanna, believes the large VIX short positioning could reflect confidence in the global economy, but it also carries the risk of complacency.

"This is worth watching closely. Once positioning gets stretched, traders can get caught offsides if volatility unexpectedly spikes," Murphy said. "Short volatility bets have increased as the economy continues to show resilience in the face of trade shocks. Earlier in the year, traders were on the wrong side and forced to cover shorts due to trade concerns."

History Rhymes?

This situation echoes past events, such as in February when the S&P 500 topped out, and volatility suddenly spiked amid concerns that then-President Trump's global trade conflicts could harm financial markets and trigger a recession. At that time, professional traders were largely betting on low volatility, only to be caught off guard by the surge.

Similarly, in July 2024, traders were heavily short the VIX before an August collapse in yen carry trades roiled global markets.

The Hunt for Effective Hedges

Despite all this, the VIX remains below 15. Last Friday, U.S. stocks rallied sharply after Federal Reserve Chair Jerome Powell reinforced expectations for a September rate cut, and the VIX plummeted to its lowest level of the year. That level is roughly 24% below its average over the past year.

With the market still in a "buy the dip" mode, many strategists recommend put spread collars on the S&P 500, as well as recently emerged lookback or reset puts, to function while the short-term market continues to grind higher. By contrast, buying VIX calls, a common hedging tool, is notably absent.

Bloomberg data shows that implied volatility for VIX calls (i.e., "volatility of volatility") is rising relative to S&P 500 put volatility. "In the current environment, plain vanilla S&P 500 puts or put spreads are likely a more reliable hedge," said Tanvir Sandhu, chief global derivatives strategist at Bloomberg Intelligence. "Additionally, the S&P 500 skew is steeper, helping improve the cost structure of put spreads."

It's crucial to remember that these analyses don't constitute investment advice, and investment decisions should be based on individual risk assessments and financial goals. A deeper understanding of market dynamics, and personal tolerance for risk is necessary before making financial decisions.