- The Cboe Volatility Index, or VIX, plunged over 30% during the election week despite what appeared to be a contested election.
- Three volatility experts told Business Insider what was behind the decline and where they saw the VIX could go for the rest of the year and beyond.
- They also shared what they are recommending to clients given the current market conditions.
- Visit Business Insider's homepage for more stories.
As investors waited for more clarity on what appeared to be a contested election, some market participants were scratching their heads over a surprisingly quick decline in the VIX.
Also known as the Cboe Volatility Index, the VIX, which measures implied volatility or the market's expectations of volatility in the coming 30 days, plunged over 30% during the election week.
The pace and extent of the decline seemed "unprecedented" to Rob Emrich especially given that the election outcome appeared uncertain for much of the week.
"This has got to be one of the fastest drops in the VIX I've seen in recent memory," said Emrich, founder of the $411 million Acruence Capital, which offers a "volatility-capture program" that gained 3,700% in March.
"The only thing we can think of is volatility may have gotten a little bit ahead of itself," he said, adding that realized volatility, which measures historical price movement, surged over the past 30 days.
He explained: "There was a disconnect between realized vol and implied vol and election uncertainty. That uncertainty seemed to dissipate a little bit when it looked like the Senate will go Republican, and the market seemed to say 'gridlock is great, we are all in.'"
Another reason behind the drop could be that investors are putting money back into work without much hedging.
"It seems to me that money is just going into the market and there's no additional hedging," he said. "So it's causing the VIX to drop faster than it normally would."
Another measure of volatility
Dave Jilek, chief investment strategist at the $9.6 billion Gateway Investment Advisers, also sees a "rather dramatic decrease in implied volatility" as measured by the VIX, but not so much by another measure — the Cboe SKEW Index.
"The SKEW rose over the course of October, and it's come down a little bit since the election, but it hasn't had the dramatic decline that the VIX has," said Jilek. "SKEW measures downside volatility expectations. And it suggests that the people who were hedged are likely rising prior to the election because people were buying downside protection."
He continued: "When SKEW drops sharply, it's usually investors who own puts selling them, that can often lead to a dramatic decline in SKEW, and we haven't even seen that yet. So that suggests that investors who are hedged going into this election, many of them are still hanging on to those hedges."
Another way to think about volatility
While many investors have watched the VIX's recent plummet with surprise, Greg Boutle, US head of equity and derivative strategy at BNP Paribas, offers a contrarian thought.
"The VIX, although it's declined a lot, is not at low levels, the VIX is still pretty elevated," said Boutle in a Thursday interview, when the VIX was hovering around 27. It had dropped to around 25 as of Friday afternoon.
"If you go back to October 23, the VIX was pretty much exactly where we are now. And at that point, the VIX was a forward-looking instrument that captured the election risk," he explained.
"Now, we're obviously behind that election risk, I think you could be surprised — if you haven't experienced the period in between — and now you could say, we've got into the election with the VIX at 27, you'd probably argue that it should be lower now."
The VIX is indeed lower now, but Boutle admits that the rapid "volatility compression" is a little bit surprising.
"But I think our read from the price action in the market generally would be that whilst the election results are far from certain, there's probably higher probabilities that people are willing to play what they expect the outcome to be now," he said.
"I think people have spoken about the risk of capital gains, tax hikes, the risk of a partial rollback of the Tax Cuts and Jobs Act, offsetting that the potential for a more expansive fiscal policy," he added.
"Now the likelihood of those things happening seems to have gradually diminished. So I think that's kind of why we've seen on a stock level, some quite sharp rotation and on an index level, real suppression of volatility premium."
The VIX could go back up
To be sure, the VIX is still above its long-run average of around 20, but Emrich sees the VIX back up in the 30s again.
"This will, unfortunately, be short-lived, because I was trading in the 2000 debacle with Bush and Gore," he said of the 2000 contested election between George Bush and Al Gore.
"That wasn't resolved until December 9, so that was almost five weeks," he added. "And Trump has made it very clear that he is going to contest and he has already done it. If that occurs, you can expect volatility to hop back up into the 30s, as measured by the VIX."
Jilek of Gateway is less sure about the impacts of drawn-out legal disputes on the VIX.
"The VIX was rising prior to the election in anticipation of an uncertain outcome and contested election. Well, that's exactly what's happened," he said.
He added: "So anyone who wanted to be protected from the market's potential negative reaction to this outcome came into it protected. There's no increased demand for protection against it, so if there's no increased demand, then that will lower the price of volatility."
However, if the legal challenges drag on for a prolonged period of time or if one of the parties resorts to "unconventional or unexpected means of gaining an advantage," then investors' appetite for protection against the unexpected could rise again, he said.
Recommendations to clients
Whether the VIX's plunge continues or is simply the calm before the spike, investors should take risk management and diversification into heart, according to Jilek.
"The market response so far this week has been quite positive, but I'm not sure that's an all-clear signal," he said. "Risk management still seems to be an important component of a diversified portfolio."
He added: "This is a particularly good time to be using options. They have advantages over more traditional risk-management approaches like bonds. Bonds may do well in particularly negative scenarios but they're not a very attractive long-term holding given how low interest rates are."
Emrich agrees that a diversified exposure is important but he believes investors need fixed income exposure.
"I think maintaining a diversified portfolio can help mitigate potential volatility going forward," he said. "And while it may feel painful psychologically, I do believe you need exposure to the fixed income market, but you have to have active managers manage your fixed-income exposure."
BNP Paribas' Boutle is already thinking about 2021, which he believes could be a good year for value stocks but with a distinction from "value traps."
"We would caution about being too bearish about value stocks. We thought going into the election that a Democratic sweep could be a good catalyst for value stocks, but it wasn't a necessary condition for value stocks to rally," he said.
He continued: "COVID is still a very big concern. We could potentially and hopefully see a vaccine in 2021, and the market could start to price in more of a full reopening. That in itself, particularly against a robust GDP growth backdrop, could be a catalyst for value to outperform."
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