MW The stock market's 'fear gauge' is trading at lows. Retail investors should take note.

By Gordon Gottsegen

The Cboe Volatility Index hasn't been this low in months - which means it may be a good time for investors to hedge against future volatility

The stock market has been acting jubilantly over the past month, with the S&P 500 up about 6% since the U.S. election and all three major U.S. stock indexes trading near all-time highs. Throughout the optimism, Wall Street's so-called "fear gauge" has been trading near lows for the year.

The Cboe Volatility Index VIX was trading at around 12.9 on Friday, which is near the index's six-month low. The VIX measures expected S&P 500 SPX volatility over the coming 30-day period by looking at options data. While it doesn't directly measure investor sentiment, it's often used to gauge how investors are positioning themselves against expectations of market volatility.

With the VIX trading near lows, the index is currently implying lower expected volatility in the immediate future.

"VIX is not explicitly constructed as a sentiment indicator," Steve Sosnick, chief strategist at Interactive Brokers, told MarketWatch. "But from a practical sense, what it tells us also is there's not a lot of institutional demand for hedging."

Sosnick says that institutional investors tend to use VIX as a short-term hedge. That's because when market volatility spikes or there's a steep selloff, VIX tends to rise as well. This hedge helps protect large institutional portfolios.

But retail investors can gain exposure to the VIX, too - through buying an exchange-traded fund or exchange-traded note that tracks the VIX, buying VIX options, or buying medium- to short-dated puts on the S&P 500. However, volume on VIX products like the iPath Series B S&P 500 VIX Short-Term Futures ETN VXX and ProShares Ultra VIX Short-Term Futures ETF UVXY has been somewhat low recently. This means a lower number of investors are gaining exposure to the VIX.

Read more: This move by the stock market's 'fear gauge' is historically bullish for the S&P 500

Although Sosnick admitted that he doesn't have very granular data on what individual retail investors are trading on the Interactive Brokers $(IBKR)$ platform, he can see the most actively traded tickers. Some of these tickers include small-cap stocks like VCI Global Ltd. (VCIG), speculative plays like Unusual Machines Inc. (UMAC) and the bitcoin play MicroStrategy Inc. $(MSTR.AU)$

"Among the most active names, there has certainly been an embrace of risk," Sosnick said.

So instead of gaining exposure to the VIX as a hedge, it seems like retail investors are instead opting to take on more risk. This might not be too surprising, considering that the postelection rally leading into a potential "Santa Claus rally" has stock-market bulls in a cheerful mood. But as pointed out by JJ Kinahan, the chief executive of Tastytrade parent IG North America, equity markets and the VIX can both change on a dime.

"It's probably prudent for people to take some of their risk off the table," he told MarketWatch.

Kinahan noted that some newer retail investors may have an "all-or-none" mentality with their portfolios, meaning they're either all risk or no risk. But professional traders tend to think in partials and are more likely to hedge their portfolios. Kinahan thinks this is something retail traders could learn from institutional traders, if they aren't doing it already.

Sosnick made the comparison of buying exposure to the VIX as like buying insurance.

"You don't hope that it pays off, but you want to be able to sleep at night," Sosnick said. "And right now, the cost of the insurance policy is relatively low."

VIX is not necessarily a forward-looking indicator because it's calculated using current volatility, Kinahan said, which makes it somewhat shortsighted. VIX doesn't tell us how long this period of low volatility will continue - but with a new presidential administration taking office in January and the potential for policy changes that affect markets, it's not a given that this period of low volatility will continue in 2025.

Retail investors may want to gain exposure to VIX while that insurance policy is still on sale.

-Gordon Gottsegen

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December 06, 2024 13:08 ET (18:08 GMT)

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