Veriton Investment

Wall Street Favors Vanilla Options Rather Than VIX to Hedge

(Bloomberg) -- Hedging is a hot topic again as Jerome Powell’s Jackson Hole speech stoked enthusiasm that the Federal Reserve will cut rates in September, sending stocks back up near record highs.

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With signs of generally extended positioning within equities, investors are debating the most effective way to protect gains before Nvidia Corp. earnings, jobs and inflation data and the Fed rate decision.

“Powell came in more dovish than feared and markets have clearly responded positively,” said Chris Murphy, co-head of derivatives strategy at Susquehanna International Group. “We are seeing some investors rolling up protection on ETFs tracking the S&P 500 and buy call spreads in SPDR Gold Shares ETFs as a part of an inflation play.”

With the market still in “buy-the-dip” mode, many strategists are touting S&P 500 Index put spreads and, more recently, look-back or resettable puts that will be useful should markets continue grinding higher in the short term. But there is a notable omission among recent hedging candidates: buying calls on the Cboe Volatility Index — normally a go-to for investors.

“Vanilla puts or put spreads on the SPX may be a more reliable hedge given the current market regime,” said Tanvir Sandhu, chief global derivatives strategist at Bloomberg Intelligence. “Furthermore, the SPX skew is steep, which helps improve the cost of put spreads.”

JPMorgan Chase & Co. strategists pointed out last week that the US deficit and Donald Trump’s pressure on the Fed may start to depress both Treasuries and stocks, suggesting a binary trade betting on the S&P 500 falling more than 5% by year-end and the 10-year yield rising 0.2%. In Europe, digital-style put spreads on the Euro Stoxx 50 Index were relatively cheap, with one-month 5% out-of-the-money put volatility at about the 20th percentile over the past year.

One reason for the omission of VIX options is cost. The calls screen as expensive relative to S&P 500 puts, Bank of America Corp. strategists highlighted in a research note last week.

This is mostly reflective of the VIX option volatility increasing relative to that for the S&P 500, which has been weighed down by rock-bottom realized moves. The so called “vol-of-vol” looks expensive on a relative basis, which is consistent with other measures of convexity generally being rich.

“Hedging is a balance of cost, decay, reliability and convexity,” said Sandhu. “Intense buy-the-dip remains a market feature and volatility spikes have reversed at record speed, hence VIX calls can be unreliable and tricky to monetize.”

Moreover, the steepness in the VIX futures term structure results in higher carry costs. As futures tend to roll down the curve to converge with the spot index — rather than the spot rising to the level of the futures for an extended period — the calls become further out-the-money, losing value.

Why the steep curve? A frequently cited reason is the re-emergence of flows into VIX exchange-traded products, which became infamous in the “Volmageddon” episode of 2018, when short VIX ETPs attracted large investments. This caused a short squeeze in VIX futures when volatility increased, ultimately wiping out products such as the VelocityShares Daily Inverse VIX Short-Term ETN.

JPMorgan strategists including Bram Kaplan noted that, conversely, recent flows have been into long funds, with more than $2.5 billion in inflows to long, levered VIX ETPs and outflows exceeding $1 billion from inverse VIX funds since April. The daily re-balance of these products results in selling of shorter-dated VIX futures to buy longer-dated contracts, further steepening the term structure.

Leveraged VIX ETPs can exacerbate swings as they buy futures when volatility rises and sell when it declines in order to maintain the target leverage. However, VIX call buyers may be more concerned with the possible volume of futures for sale in the next stock slide as fund investors cash in winning trades.

Potential VIX call buyers will also have the memory that the late-February selloff was characterized by low volatility, where S&P 500 puts outperformed. While those investors who bought VIX calls just before April 2 did better, the outperformance versus simple equity puts may still not be sufficient to justify a big allocation within their hedging books.

The biggest event before the Fed meeting in September is Nvidia earnings this week. Options are implying a 5.8% move in shares after the report, in line with the average swing following the last eight quarterly releases. One-month volatility is in the 32nd percentile over the past year, and volume has been trending lower since early 2025.

“As of yesterday, people were not too focused on Nvidia earnings, at least in the options market,” Steve Sosnick, chief strategist at Interactive Brokers, said Friday. “But they should be! It’s the most important stock in the market, both by weight and by psychological impact. If they fail to ratify the AI enthusiasm that underlies so much of the current bull market, that could bring about a big change in sentiment.”

--With assistance from Natalia Kniazhevich.