Election fears send US investors searching for protection

Wall Street’s volatility index, or fear gauge, is at levels not seen since the UK’s shock Brexit vote.

Investors buy Volatility Index derivatives to guard their portfolios from sudden stock market drops. Pic: AP

US investors are buying fear.

The CBOE Volatility Index, Wall Street’s fear gauge, is up for a sixth consecutive day to levels not seen since the UK’s surprise vote to leave the European Union.

The rise has now flipped the futures curve, reversing the premium that VIX buyers usually pay to buy portfolio protection.

The VIX uses S & P 500 options to measure traders’ expectations for stock market swings. A rising VIX highlights increased uncertainty.

Overnight (AEDT) the index rose as much as 19.75 per cent to 20.43, which would be the highest settlement price since June 27, four days after the Brexit vote. The current run-up is also the longest since December 2013.

Since the VIX typically rises when the S & P 500 index falls, investors buy VIX derivatives to guard their portfolios from sudden stock market drops. That protection is growing more popular as the US presidential race nears. Republican nominee Donald Trump has been gaining ground, increasing the odds of a surprise upset after weeks in which polls favoured Democratic candidate Hillary Clinton.

Net-long positions are near-record highs in volatility exchange-traded funds, said Pravit Chintawongvanich, derivatives strategist at Macro Risk Advisers in a Nov. 1 research note.

“If Clinton wins the election, we think volatility could collapse in a big way,” Chintawongvanich wrote.

The two largest ETFs that profit from rising volatility garnered $US406 million in inflows in October, according to FactSet. On the other side of the trade, the two biggest ETFs that profit from declining volatility lost $US321 million.

Betting on a rising VIX can mitigate losses in a downturn, but it comes at a cost. Because uncertainty increases with time, the further away an anticipated downturn is, the more expensive it is to insure against. That means that VIX futures for this month are typically cheaper than next month’s contracts, which are cheaper than the month after that, and so on.

Some long ETFs maintain their exposure through a combination of this month’s VIX futures and next month’s. Every day, they sell contracts that are nearing expiration and buy contracts for the following month. Put simply, the ETFs sell low and buy high, almost every day.

Volatility short sellers typically pocket that premium by doing the reverse: buying low and selling high. Shorts can make money when volatility declines. But even if volatility is relatively flat — and sometimes even if it rises — sellers can still reliably take their cut by exploiting the futures curve.

But sudden spikes in volatility like that overnight are a double-whammy for shorts. First, they lose money on the wrong-way bet. Second, when the futures curve suddenly inverts, shorts go from collecting the premium to paying it. The longer the market stays that way, the more shorts will lose.

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