Are Investors Sitting Ducks Taking on Risk and Shunning Hedges?

Talking Points:

• Volatility measures like the VIX offer tradable instruments but more commonly measure hedging costs and exposure
• With so many markets' volatility measures at exceptionally low levels, it seems traders are shunning safety
• While the near-term 'fear' measures are low, the cost of protection beyond one month is actually rising

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Trading volatility is one of the favorite pursuits for market participants in these otherwise dithering financial conditions. However, while volatility itself is a trade outlet, it is more prominently a measure of 'risk' and exposure. Indexes like the VIX - based on equities - can be viewed as a measure of the cost to protect underlying positions from sudden swells in volatility and more specifically abrupt moves against the prevailing trend (risk on). On this basis, it seems the market is a sitting duck. With risk-oriented assets reaching higher levels - led by a record for the S&P 500 - the exceptionally low level of implied (expected) volatility seems extreme complacency founded on absolute moral hazard. Yet, the markets may not be as aloof as these front-line measure may insinuate.

The standard implied volatility measures that are referenced in the financial media are derived from options with a standard 30-day forecast period. Given the performance of benchmarks like the S&P 500 over the past six months and the extent of general complacency in the financial system amid extreme monetary policy, it comes as little surprise that there is little appetite for a near-term insurance contract. A sunk cost in these already-lowing yielding markets would be a clear disadvantage. Yet, the probability that fundamental and financial imbalance will lead to a correction three or six months forward seems far more reasonable to this increasingly skeptical market. And, we can see the appetite for longer-dated hedges in distant volatility pricing. We take a closer look at the market's preparedness and complacency to rough seas ahead in today's Strategy Video.

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