Buy VIX Calls before US Election - Goldman Sachs Views

Allen Zhou, Cosmos Quant Investment, nzhou@cosmosquant.com

Goldman Sachs (GS) believes that current low implied volatility, the upcoming October earnings season, and the elections provide an attractive opportunity for investors to hedge against a potential rise in volatility:

• VIX calls offer a superior hedge compared to SPX puts if volatility increases due to seasonality or a macroeconomic environment with only moderate S&P 500 price movement.

• GS (in-house model) estimates the VIX could reach 24.5 under the current macroeconomic conditions, and 33 in the event of a 1-standard deviation economic shock. This estimate is driven mainly by lower unemployment and ISM new orders.

• Seasonality: 1) Historically, the VIX has increased by 6% from September to October, and 2) it is currently below its multi-year average of 22.

• The major risks currently facing investors are related to market uncertainty, potential tech stock drawdowns, and rate changes.

Why Hedge Using Options? Available Choices

Options provide investors with an opportunity to hedge against asset price declines at a fixed cost while maintaining full upside exposure. The liquidity in the options market has significantly improved over the past decade, enhancing investor flexibility. Here are the available choices:

• VIX Calls: VIX calls would act as a superior hedge compared to SPX puts - if the market rallies after purchasing SPX puts, the put becomes much less relevant for future modest market declines. Conversely, VIX calls can provide ongoing protection even if the market initially rallies, with VIX remaining stable before eventually spiking.

  
  

• Sector ETF Options: In addition to VIX options, sector ETF options can serve as effective hedges for specific risks, such as those in technology, financial, or energy sectors. These options allow investors to target their hedging strategies more precisely.

Scenario Analysis (Next 3 Months)

Scenario 1 - If you expect volatility to rise ahead of upcoming macroeconomic catalysts but anticipate only a moderate decline in equities,

• Buying VIX Calls: This is more effective than SPX puts for this scenario. VIX calls benefit more from rising volatility, and a moderate equity decline may not be sufficient to make SPX puts profitable. Additionally, VIX calls provide a better risk-reward ratio in this environment due to their direct sensitivity to volatility changes.

Scenario 2 - If you expect volatility to trend lower and believe the S&P 500 will either experience a 10% drawdown or make a moderate upward move,

• S&P 500 97-90% Zero-Premium Put Spread Collars: This hedge offers protection against a 10% decline at no cost by sacrificing some upside participation. Additionally, being net short on volatility (two short vs. one long options position) means these collars benefit from volatility decreasing below implied levels.

Scenario 3 - If you expect volatility to trend lower and expect the S&P 500 to either experience a 10% drawdown or make a large upward move,

• S&P 500 97-90% Put Spreads: These provide downside protection while maintaining some upside participation. Given higher implied volatility, put spreads offer a lower-cost alternative compared to buying outright puts.

Scenario 4 - If you expect volatility to rise and the S&P 500 to either decline by 20%+ or make a large upward move,

• Buying S&P 500 20% OTM Puts: This is the ideal hedge for this scenario. Long puts protect the portfolio from a large decline (acting as a tail hedge) and benefit from increasing volatility while maintaining upside potential. The out-of-the-money (OTM) nature of these puts means they can offer substantial returns if a significant market drop occurs, effectively protecting against tail risks.

References

Portfolio Hedging Toolkit - Buy VIX Calls, Arun Prakash, Goldman Sachs Derivatives Research, 19 September 2024