Market Hedging in the Calm Before the Storm

Market Hedging in the Calm Before the Storm: Is Now the Time to Hedge Your Bets?

The Calm Before the Storm? Is Now the Time to Hedge Your Bets?

Hey everyone,

It feels like the market has been on an unstoppable climb lately, doesn’t it? We’re seeing the S&P 500 hitting new highs, and a general sense of calm seems to have settled over the financial world. But what if this tranquility is a setup for something more volatile? This week, we’re diving into some fascinating market dynamics that suggest now might be the perfect time for effective **market hedging** strategies, because you should “hedge when you can, not when you have to.”

Market Hedging: A Shift in Market Focus

For months now, the market’s biggest fear has been what we call “left-tail” risks, scenarios with extremely negative outcomes, like a major tariff tantrum. But as trade deals have progressed and initial fears about inflation (driven by tariffs) have subsided, the market has shifted its focus. We’ve entered a “right-tail” environment, where positive surprises, particularly in corporate earnings and economic data, are driving the rally. This is creating a powerful backdrop for a strong market, and smart investors are considering **market hedging** to protect against a potential downturn.

Consider these points:

  • Tariff Fears Fading: The market has largely moved past tariff concerns as trade deals are being rolled out, and some “worst-case” scenarios for inflation have been avoided.
  • Strong Earnings: After the initial “tariff freakout,” Q2 earnings growth has been robust, with a high “beat” rate. Analysts are now upgrading their 2026 earnings-per-share (EPS) estimates, following the market’s momentum.
  • Easing Financial Conditions: As markets rise and volatility drops, financial conditions are easing, boosting consumer confidence. This is creating a positive wealth effect, fueled by rallying equities and crypto, and even strong returns on cash.
  • Solid Economic Growth: Growth remains above 2%, nominal GDP is hovering around 5%, and we’re at “full employment.” Recent positive surprises in initial and continuing jobless claims, non-farm payrolls, and retail sales all point to a resilient consumer.

Betting markets are currently showing the lowest odds for a 2025 recession this year, even as the S&P 500 makes new highs. This indicates a strong belief in continued positive momentum.

The Rise of Volatility Control and Leveraged ETFs

A period of unusually low volatility (“rVol crash type event”) is driving major shifts in how capital is being allocated:

Vol Control Strategies Ramping Up:

Volatility control funds, which aim to smooth out market swings by adjusting risk, have significantly increased their exposure to U.S. equities. In the past month alone, an estimated $124 billion has flowed in, and over the last three months, that figure jumps to $158 billion.

Leveraged ETF Demand Soaring:

Retail investors are piling into leveraged ETFs, which use derivatives to amplify daily returns. Assets under management for these funds have hit a record $139.8 billion which is an all-time high. This surge is also pushing their end-of-day rebalancing needs to historic levels, often resulting in late-day buying pressure in the underlying equities.

VIX gets no love these days

Here’s where it gets interesting – and potentially counterintuitive. Part of the reason for the “Low Vol / Low VIX” environment is a perverse form of “hedging” itself. Traders and funds are increasingly “long” equities, and therefore need to buy S&P downside hedges. However, these hedges have been consistently losing money due to the market’s relentless upward trend and the “gamma” (a measure of option price sensitivity to volatility) bleeding them dry. As a result, many are giving up on these SPX hedges, making proactive **market hedging** seem futile.

A significant factor here is the Leveraged VIX ETN space. Their AUM is currently at the 90th percentile, and “share creates” (new shares issued by the ETN) have been at the 100th percentile over the past few months. These are being used by retail investors (especially from Korea) to hedge their long U.S. equities exposure.

However, this demand for forward volatility (VIX futures) is being exploited. Traders are selling the near-term VIX futures and buying longer-dated ones, capitalizing on the extremely steep VIX curve (at the 98th percentile). This, along with owning short-dated VIX puts, cumulatively pushes the front-end VIX (the near-term volatility) even lower.

The “Smooth Glide” Risk-Reward Environment

The current environment, characterized by low realized volatility in the S&P 500 (e.g., 5-day realized volatility at 5.66, 10-day at 4.367, 20-day at 6.592), has been described as a “smooth glide” risk-reward environment. This means that selling daily SPX puts (both at-the-money and 25-delta puts) has been remarkably profitable, even outperforming simply holding long stock over various trailing periods. The Sharpe Ratios (a measure of risk-adjusted return) for selling daily SPX puts are near multi-year peaks, highlighting how attractive this **market hedging** strategy has been.

Market Hedging in the Looming Volatility Squeeze

While the current calm is enticing, there’s a significant potential for a “Vol Squeeze HIGHER” if we see any reason for a spot equities sell-off. This could even be triggered by “profit-taking gone wrong,” as the sheer amount of long positioning and leverage in the market could easily lead to a rapid downturn.

Here’s why:

  • Extreme “Vega to Buy”: The cumulative “Vega to Buy” (the sensitivity of an option’s price to volatility) in a +10 Vol Point “shock” is at an extreme 92nd percentile. This simply means there’s a lot more VIX that needs to be bought in a volatility shock upwards than there is to sell in a volatility crunch ( as we are undergoing now).
  • Historical Precedent: Long periods of “calm,” like the recent streak of 16+ consecutive days where the S&P 500 moved below 0.8%, have historically led to VIX forward returns and S&P 20-day realized volatility forward returns beginning to move higher.

With the VVIX (volatility of VIX) back in the 80s and implied volatility (iVol) in the teens, buying VIX Calls outright presents a “convex hedge”. A hedge that provides outsized returns in a sharp downturn. From a value perspective, with 1-month VIX Call Skew at the 85th percentile and 2-month at the 93rd percentile, call spreads are also setting up nicely.

The prudent move is to prepare for a potential storm while the sun is still shining, and that preparation begins with intelligent **market hedging**.

The Bottom Line: Market Hedging When You Can, Not When You Have To

The market is currently in a sweet spot, but the underlying dynamics suggest that this period of low volatility may not last forever. The heavy long positioning, coupled with the mechanics of leveraged ETFs and the perverse hedging flows, creates a scenario ripe for a sudden volatility spike. As a result, robust **market hedging** strategies are more critical than ever.

As the saying goes, it’s always better to be prepared. Consider adding hedges to your portfolio now, when they are relatively inexpensive and the market is calm, rather than waiting until a correction forces you to buy protection at much higher prices.

Stay safe out there,

The Falling Editor

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