Cheap Macro Hedges And How VIX Has Always Been A Poor Early Warning Signal

Tyler Durden's picture

We have time and again pointed to the warning signals being sent from credit markets, FX volatility skews, and equity option volatility technicals (skews and implied correlation) but while the mainstream media is behooven to watching every tick in the 'fear index', the 'simple' VIX has consistently underpriced risk in the face of danger. Furthermore, this implicit optimism, leaves equity options among the cheapest macro hedges across asset classes currently (especially relative to FX, Rates, and Credit). FX options offer the next cheapest hedge with credit already notably stressed. BAML's research group finds Nikkei (Japan), Nifty (India), and ASX200 (AUS) puts attractive as global macro (crash beta) hedges with Copper, IG, and HY credit the least attractive at current levels.

Equity implied volatility is currently screening as the cheapest place to buy protection across asset classes. Throughout 2011, equity repeated its historical behaviour of underpricing risks flagged by other asset classes only to react strongly in sell-offs.

Ahead of the Lehman crisis in 2008, the first round of the Euro sovereign crisis in 2010, and the second round in Aug 2011, equity volatility was consistently among the most optimistic of the cross-asset hedges.


BAML believes this will continue in 2012 and recommend screening for dips in equity option prices to take advantage of this behaviour. Implied risk in FX options is next lowest and also offers, similar to equity, the most potential upside in a severe 2008 style sell-off.



This chart illustrates where the best hedging value is currently across asset classes. 

[the chart above measures the expected relative benefit per unit of cost of
owning a put on any asset vs. a put on the S&P 500. This is based on
the peak to trough drawdown each asset has recorded when the S&P
has fallen by 10% or more in a month and approximates an expected payout


For example the expected gain from owning a hedge on the Nikkei 225,
even under the minimum beta the Nikkei has exhibited to the S&P
since 2008, still suggests puts will payoff over 1.5 times as much as
S&P puts given current costs
. In the best case scenario, they are
expected to pay off over 2 times S&P puts.]

Equity put options on the Nikkei 225 (Japan), Nifty (India), ASX 200 (Australia), commodity puts on Aluminium and FX puts on AUDUSD stand out as good value. Aluminium hedges would be particularly attractive for hedging the risk of a hard landing in China or spill over effects from Europe into EM economies according to our commodities research. ASX200 and AUD are also implicit China hedges due to their commodity dependency and AUD is overvalued due to excess pricing of US easing according to our rates and FX teams.

So the next time you hear the VIX is up or down or sideways, treat it with the contemporaneous weighting it deserves (or potentially discount its eternal optimism entirely) and remember that while it is frequently cited, the availability bias needs to be suppressed when investing.


Source: Bank Of America Merrill Lynch

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WhiteNight123129's picture

1% of GDP in CHINA = 8% Iron price, there are several sources for that, the Fitch -Oxford report back in December 2010 and hte IMF report. The first report does a formal Copper - China GDP assessment in percentage point at 6% and not a formal on Iron ore, but the Fitch Oxfor and the IMF both point that more of the globally traded Iron goes to China in percentage as opposed to Copper. No wonder Chanos is short VALE (which is the most iron ore exposed company). 1 Sky scrapper = 160 km of rails in steel consumption. 13% of GDP in China is construction and IMF May report shows that property cycle take years to settle once they pop. That is precisely why one should expect property to bottom in the US, hence the MTG trade from Kyle Bass which is essentially writing puts on home prices in the US, while property is far from bottoming in China (check Numbeo affordability indeces and other IMF data). Today the steel industry association points to 0.47% of profit margin for the steel industry in China down a wopping 80%. The head of the association of steel manufacturing in CHina points to a turning point in property in China (laughable). Affordable housing is nowhere near to be enough to sustain demand for iron ore. Remember that 35% of world steel is made with scrap. Remember Hugh Hendry CDS position on Nippon Steel.... And yes VIX = dumb money. Look at MArgin at VALE in 2009 when the world steel consumption was down 9% including China pushing up 15%. I think the situation is worst now because China can not propel up again while the world capacity has increased much faster than world GDP since then..... VALE is going to get creamed (I would not say so about other mining, but iron ore is the most abundant mining commodity with an end in a totally oversupplied steel industry (CHINA local party official having each a local steel mill). The central Gov is not against closing those actually the central gov tried to do that in the previous 11th plan... SHORT!!!

jcaz's picture

VIX exists for the CNBC talking heads to appear "market savvy", as they marvel how a drop MUST mean that stocks are about to go up.....

HedgeAccordingly's picture

i agree.. the VIX did not foreshadow this price action yesterday... its for pikers -

Snakeeyes's picture

Should be renamed The Dix!


Dr. Engali's picture

I'm sorry only a fool looks to the vix for guidance on when to buy. When the vix is leveled off I'm selling to the bigger fool. 

ZeroPower's picture

The talking heads dont know VIX from their assholes. Historical vol is implied volatility (IV): i.e. are options cheap or expensive, today.


Captain Kink's picture

Is the vertical axis (stress level) measuring prices of these hedges, relative to norms, or participation levels, or what?  If it is price level, it looks like the cat is out of the bag...we've all seen this slow motion train wreck happening for years now, and if we're all prepared for it, can it still occur?

Schmuck Raker's picture

The green dashed line is "expected benefit" of a put on S&P 500.

El Viejo's picture

Good question. Of course a systemic failure of Europe is unavoidable without huge intervention and so I wonder if 'we' are all prepared for it.

It also begs a bigger question, Is China or another war the real Black Swan??

samsoro's picture

when you look at VXX (ETF for VIX), performance is much worse than VIX, I assume because theta. You have to pretty much be right on about impending risk spike for catching much upside.

Stax Edwards's picture

Trading VXX is a joke.  Vegas is much more fun.

Apocalicious's picture

It's negative roll yield. Look at the term structure. Buy VXX when the VIX is backwardated, short it when it's contangoed.

haskelslocal's picture

VIX measures volatility in only one direction, which, by definition, cannot be a volatile. Short term, anything can be volatile around a mean in either direction wheather it's a positive or negative number. Market jams up? Well that's volatile as well but reduces the VIX which nullifies it as a metrix for equites.   

Mercury's picture

VIX has consistently underpriced risk in the face of danger. Furthermore, this implicit optimism, leaves equity options among the cheapest macro hedges across asset classes currently...

Unless the understanding that the SPX will only be allowed to fall so much is already priced into those equity options. 

Ruffcut's picture

What would you expect from the CBOE. Criminal Buttfuckers of Evil.

ItsDanger's picture

I always found the VIX rather useless.  It just seems to measure negative or positive trends in market moves.  Shouldnt a volatility index increase with actual volatility not just downward trend?

howswave5workingforyou's picture

i've been looking at relationships between vix, credit spreads, and fx volatility for some time. i don't find things particularly out of sync at moment. actually if anything index skew in europe looks too high. i would be selling equity index skew and picking up something that like bund puts or swiss govies for more attractive systemic exposure. futhermore if you think there is more systemic risk around the corner Yen or Canadian volatility will not remain this low. 


howswave5workingforyou's picture

sorry. i should probably right something like. "VIX is for DIX. staglation to you die. S&P going to 400 bitchez. buy gold, the system is broken". 

pcrs's picture

Every new entity can run up a debt of 100% of it's underlying GDP, untill a new entity is placed on top of it, fresh and with no debt, ready to rock and roll.

optionwriter's picture

The fed will not let the S&P fall to 400 during a election cycle. PERIOD!!