Investment Committee - July 2025

Mid Year Assessment

In a financial landscape often characterized by short-term volatility, understanding and mitigating its impact on portfolios is paramount. This article delves into the current state of market volatility, highlighting key indicators and proposing strategic hedging solutions designed to protect assets. The nuances of volatility exposure, the critical role of tail hedges, and actionable strategies for navigating potential market shifts will be explored.

Volatility and Its Impact

A pervasive short-term volatility is observed across global markets. Most investment strategies and investor incentives are found to be negatively affected by increases in volatility, meaning they are adversely impacted when market swings become more pronounced. This broad susceptibility underscores the importance of proactive risk management.

In contrast, upside in the markets is often attempted to be captured, or downside hedges are purchased, by many option buyers, typically those acquiring moderately out-of-the-money strikes. However, pricing extreme tails (very out-of-the-money strikes) is found to remain challenging even for seasoned professionals. During periods of market calm, these options can be observed to become undervalued due to a lack of demand or because sellers believe them to be too improbable for assignment.

The Power of Well-Designed Tail Hedges

It is crucial to understand that well-designed tail hedges are not akin to capital allocations with fund-like characteristics. A substantial offset to a portfolio during a major market downturn is expected to be generated by a well-implemented tail hedge with a minimal capital outlay. The fundamental principle here is that hedges are bought when they can be, not when they must be. This proactive approach allows protection to be secured at more favorable terms before market stress necessitates urgent action.

Current Market Signals and Volatility Outlook

Currently, higher volatility is called for by most of our relevant signals. It is evident that these signals are to prompt risk being taken off the table within the week.

The low readings from the oscillators that are followed, all of which are indicators referring to the US equity market, are not considered sustainable. These are mean-reverting time series that are observed to stay at extremes for a relatively short period. In the past, investors had almost always been led to pause adding risk to their portfolios by such prints.

The underlying logic is straightforward:

The VIX index is observed to trade below 17% again, a level implying a daily move of 0.7% for the S&P 500 – or 3.9% in a month. Furthermore, correlations are also observed to trade low.

For the VIX to stay low, correlations are required to remain low. This is because Index Volatility ≈ Weighted Average Volatility of Components × √Correlation of Components.

This relationship means that for every stock purchased, some other needs to be sold. If investors deviate from these rules and buy stocks across the board, then correlations will rise. If correlations rise, volatility must rise or else short volatility positions risk being loaded at low levels. Consequently, something in the market dynamics is believed to be about to give.

Actionable Hedging Strategies

Typically, whenever the sequence of events reaches the current point, hedges are found to make money more often than not. Current strategic ideas that are being considered include:

• High beta tail bets: For example, Tesla put spreads.

  
  

• Skew exploitation: This involves SPX index risk-reversals.

  
  

• A VIX July 20/30 call-spread for $0.60: This offers a great payout if VIX spikes to, say, 25% – and a maximum payoff x16.7!

  
  

While this process might appear too technical, it is currently observed to result in the best risk/reward ratios available. Overpaying is avoided; low premium decay is experienced; quick rebound can be expected; and no need for a staggered, laddered entry is present.

Conclusion

It is recognized that there is no "solution" to the exuberance that has brought stock exchanges to new all-time highs. Rich valuations and complacency are considered a chronic condition; simply a long-standing situation that is being experienced. This background requires a multilayered effort to manage, one of which is timing when and what hedges to endorse. At least for the timing part, the first weeks of July are viewed as peak contenders to position for higher volatility.

Authors: John Couletsis and Kostas Metaxas