(Bloomberg) -- Investors are starting 2025 with a conundrum: how to protect against potentially bigger risks while not missing out on a stock-market rally.
On the one hand, just about every sell-side strategist has an S&P 500 Index target above current levels, and the US economy remains strong. On the other, long-term Treasury yields are flirting with the key 5% level, with the dollar reaching a high after Friday’s hotter-than-expected jobs report. All this while Donald Trump is about to be inaugurated as US president for a second time, showing every sign that he’ll inject as much volatility into markets as he did the first time around.
After two years of caution on equity markets — with consensus touting bonds to outperform and a moderate recession to ensue — Wall Street strategists appear to have thrown in the towel. After all, who will want to explain to investors why they missed out on yet another year of 20% returns for US stocks?
History does not judge capitulation by bears too well: It can be seen as the inflection point for markets, and buy-side portfolio managers are often wary of a clean sweep of bullish sell-side strategists. As a consequence, hedging may be more in focus this year.
For stock investors looking for the best of both worlds in 2025 — riding the rally with cheap crash protection — several sell-side strategists are suggesting variations on a theme: buying calls on the Cboe Volatility Index, subsidized by the sale of S&P 500 puts.
According to UBS Group AG, the strategy has provided a return similar to just going long the stock market over time. The added benefit is that it outperforms if volatility spikes as it did during previous flash crashes, such as the one last August.
Bank of America Corp. strategists take a systematic approach with dynamic weightings that change depending on VIX positioning risk. They note that the index of stock swings developed a significant imbalance as end-dealers built short delta and gamma positions ahead of the early-August selloff, and that VIX call skew tends to be steeper when market makers become shorter option delta.
With VIX call skew still quite high and Bank of America saying that position imbalances did not fully reset post the Aug. 5 volatility spike, this long convexity strategy demands immediate attention from investors.
That kind of systematic trade has attracted banks offering quantitative investment strategies, also known as QIS, which use mathematical models and algorithms to identify opportunities. Data provider Premialab notes that such bets can help mitigate portfolio risk, with back-testing of a collection of defensive strategies seemingly achieving tail-risk protection with reduced carry cost.
“Buy-side clients are increasingly incorporating long VIX calls and tail-risk hedging strategies into their portfolios,” said Adrien Geliot, chief executive officer of Premialab. “These approaches enable clients to manage downside risks and protect against volatility spikes more efficiently in today’s volatile markets, often without the significant drag on returns associated with traditional hedging methods.”
Some on the buy-side question how effective QIS is in practice, with what’s known as overfitting of back-testing — when the model is too closely aligned with a limited set of data — often a big concern. Even sell-side specialists on the subject point out that specific systematic trades such as this long VIX calls, short S&P 500 puts may not be effective if they’re implemented in too regimented a manner.
“This strategy may not perform optimally during slow, grinding selloffs, like those experienced in Q4 2018 or 2022,” said Arnaud Jobert, co-head of global strategic indices at JPMorgan Chase & Co. “We would generally prefer a more dynamic implementation, which can look at relative value opportunities between the two.”
Antoine Bracq, head of advisory at Lighthouse Canton, shares a similar view.
“The long VIX calls and short SPX puts strategy adds unnecessary complexity without delivering meaningful value,” Bracq said. “Additionally, you may need to fine-tune the ratio between the two legs, which introduces a second layer of complexity, further reducing the strategy’s appeal.”
For the short term, JPMorgan’s US equity derivatives strategists suggest buying straddles expiring shortly after the Jan. 20 inauguration. Those take advantage of potential volatility from policy announcements around then that may send certain sectors swinging, such as consumer or technology in the case of tariffs.
Dollar Bulls
As the dollar rallies, options traders have bolstered their outlook on an even stronger greenback. One-month risk reversals on the Bloomberg Dollar Spot Index traded at 0.54% in favor of calls on Friday after the US employment report, the most bullish since early July.
Rates Surge
In the build-up to the strong jobs data, rates traders had been adding to short positions in 10-year futures, fueling rising yields to multi-month highs. The post-payrolls extension of the Treasuries market selloff appeared to attract some dip-buyers and covering of short positions as 30-year yields briefly topped the 5% level, signaling tactical positioning remains the dominant driver of near-term price action in the bond market.
In Treasury options, post-jobs action included the selling of 10-year put structures, also consistent with the unwind of short-term bearish plays over the report. Key risk events ahead include CPI and Trump’s inauguration, which once passed could pave the way for a stronger hold on bond0-market expectations.
--With assistance from George Lei and Edward Bolingbroke.
