Can Hedging Really Support a Struggling Market?

The war in Iran is causing a lot of uncertainty, and as a result, investors have rushed to hedge their portfolios. This is apparent in the SPDR S&P 500 ETF Trust’s (SPY) 20-Day implied volatility (IV) skew, which has climbed to levels not seen since 2021.

For the indicator, I compare the IV of the SPY call and put options that are 5% out-of-the-money (OOTM) and expire in about 30 days. Then, I’m averaging the IV over the prior 20 trading days before finding the ratio. The ratio recently touched 2.0, which has happened just a handful of times over the last decade.

In theory, more hedging can support the market. When investors are hedged, they’re less likely to sell if their positions turn against them. This can dampen pullbacks and make sharp selloffs less likely. In the analysis below, I’ll look at what happened in the past after the SPY IV skew rises above 2.0.

SPY IV Skew Above 2.0

Using options data that goes back to 2010, the first time we saw the SPY IV skew get to 2.0 was in 2014. The table below shows only the first signal over the previous month of trading. It’s rare that we see the put IV double the call IV. So, unfortunately, we have just seven other instances of this occurring, which is not enough to draw any strong conclusions.

Although we only have seven data points, let’s still look at the numbers. We see underperformance over each time frame (from one month to one year) based on the average return. However, there’s validity to the idea that these signals represent hedging and support the market. The standard deviation is lower going forward after these signals. The exception is the three-month standard deviation, which was heavily affected by the severe downturn during Covid in spring 2020.

The last time we saw this was in 2021, in which the market was doing fine for six months and then turned lower in 2022 as inflation hit high levels, the Fed became more hawkish, and a war broke out with Russia invading Ukraine (those drivers seem familiar).

In conclusion, we see familiar headwinds for this market but the recent spike in the 20-day SPY IV skew suggests investors have hedged, which tends to make pullbacks more manageable.