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Record hedging proves timely as election selloff hits stocks
[NEW YORK] The stock market's in free fall but for equity traders who amassed record hedges before Election Day, it's not quite as bad as it looks.
Investors had months to ponder the prospect of a rout and data from volatility markets show they spent liberally on instruments designed to cushion the blow. Billions of dollars of what amounts to equity insurance was bought and sold in the week before the election, a reprise of precautions that preceded the Brexit vote.
One clear indication of the degree of hedging: The number of outstanding futures on the CBOE Volatility Index has climbed steadily since June and for the last three months has been higher than at any time since the bull market began. Trading has surged in practically every corner of the market were the securities are sold, from contracts tied to the S&P 500 Index to bets on volatility products.
"We shorted equities and we shorted bonds, so we're going to do well in this market because we're short the risk market," said Zhiwei Ren, managing director and portfolio manager with Penn Mutual Asset Management which oversees about US$20 billion.
"If Trump wins, the risk market will selloff. The decision I have to make in the next few days, the next few hours, is when do I cover my shorts. "
Global markets buckled Tuesday night after voting results showed Donald Trump leading in key battleground states including Florida, North Carolina and Ohio. Futures contracts tied to the S&P 500 slid 4.2 per cent at 10.38pm in New York.
Deploying hedges around market events such as elections requires something like perfect timing, said Mark Heppenstall, chief investment officer of Penn Mutual Asset Management, which oversees US$20 billion.
Mr Heppenstal's firm doesn't own any hedges specifically designed for Election Day but profited from volatility trading when markets swooned last week.
"You need to be pretty quick to lift the hedges after the result since markets would likely bounce back quickly after a Trump victory was digested," he said.
"It's usually the unexpected outcomes when hedges are the most effective as opposed to something like today when everyone knew the potential outcomes."
Much protective trading in the last 10 days was concentrated on the VIX, the options-derived gauge that goes up when markets get turbulent and therefore moves in the opposite direction of the S&P 500 more than 80 per cent of the time. Futures tied to the index have traded with increasing urgency since the June Brexit decision and set all-time records in October.
Weekly open interest in one-month VIX futures reached 1.1 million in the week ended Oct 28, almost 70 per cent higher than the average over the past three years, according to data compiled by Bloomberg. Open interest has averaged 169,866 contracts on a daily basis in 2016, 30 per cent higher than in 2015.
"Hedging is costly, but it's something people have to do," Pravit Chintawongvanich, head derivatives strategist at Macro Risk Advisors in New York, said in an interview on Bloomberg TV Tuesday.
"If you have to explain to your boss on Nov 9 why you weren't hedged and Trump ended up winning, you're going to be in a bad spot."
Another hedging class, put options tied to biggest exchange-traded fund tracking the S&P 500, saw open interest surge to 16.7 million contracts on Monday, close to the most in two years, according to Bloomberg data. The measure climbed to 17.3 million on Sept 16, the highest since Nov 2014, and 29 per cent above the average since the start of 2015, the data show.
Demand has been so great for the contracts, which pay when the S&P 500 declines, that open interest has swelled to about double the same measure for calls, close to the most since April, according data compiled by Bloomberg. That's also high relative to the average ratio of 1.75 for the past six months.
The CBOE Equity Put/Call Ratio climbed to 0.78 on Friday, the highest since June and also matching a level reached in September. The measure was at an average of 0.63 from July 8 through the end of October, a period over which the S&P 500 was locked in a 64-point range.
"The put-call ratio and the amount of puts put on over the last week are pretty impressive, and that's a measure of fear," Mike Baele, managing director at US Bank's Private Client Reserve in Portland, Oregon, said by phone. The firm oversees about US$136 billion.
"It's just too costly not to be protected. Odds markets had a Trump victory at 20 to 25 per cent probability," he added.
"For the traders that are looking for black-swan type events, that's pretty interesting relative to what those traders are used to seeing."