Kevin Davitt, John Hiatt, Cboe - Relative To The Overall Portfolio, Small Allocations To Tail Risk Ideas Can Have An Outsized Impact | #279

Episode Summary

Executive Summary: The episode explores volatility, the VIX, and tail-risk hedging with two CBOE experts. They explain what volatility measures, how the VIX is constructed and used, common misconceptions, and why 2020’s market turmoil revived interest in hedging. The discussion emphasizes behavioral benefits, the complexity of implementation, and the growing accessibility of options and exchange-traded products.

Main Topics: What volatility is and how the VIX works (Priority: 5/5): The guests define volatility as the market’s rate of change and explain the evolution of the VIX from an implied-volatility gauge to a broader, tradable benchmark for expected equity-market variance. How investors use and misuse the VIX (Priority: 5/5): They describe the VIX as a forecast of forward uncertainty and a market sentiment signal, while warning against treating it as a rule that must always move inversely to the S&P 500. Tail-risk hedging and portfolio protection (Priority: 5/5): The conversation covers why investors seek protection after crises, how hedges can reduce behavioral mistakes, and the tradeoffs between index puts, VIX futures/options, and other structures. 2020 as a stress test for volatility strategies (Priority: 4/5): The speakers highlight record option activity, elevated volatility, and how the pandemic reset investor expectations after years of unusually calm markets. Benchmark indices and volatility products (Priority: 4/5): They discuss CBOE benchmark indexes like BXM, buy-write strategies, VXTH, and the role of implied correlation and variance futures in evaluating or implementing hedges. Behavioral finance and investor communication (Priority: 4/5): A major theme is that hedging can improve decision-making during drawdowns, and that strategies must be explained clearly to clients and committees to be adopted effectively. The future of options education and market access (Priority: 3/5): The guests talk about rising adoption of options by newer investors, exchange-traded products, and CBOE’s expansion in education, research, and European market presence.

Key Arguments: Volatility is not just a negative market event; it is a measurable rate of change and an unavoidable market constant. The VIX is best understood as a forward-looking forecast of uncertainty, not a crystal ball or a mechanical inverse mirror of the S&P 500. Users misuse the VIX when they insist it must always rise when stocks fall; the index can be useful even when both move higher or lower together. Tail-risk hedges are valuable mainly because they change investor behavior during crises, helping people avoid panic selling and enabling opportunistic rebalancing. Hedging should be tailored to the investor and timeframe; there is no universal correct hedge, only structures that fit different objectives and constraints. Small allocations to convex hedges can have outsized portfolio impact during extreme events. 2020 accelerated both options adoption and education needs, making the industry more focused on explaining risks and utility. Benchmark indices such as BXM and VXTH help institutions compare and understand option-based strategies in a standardized way. Implied correlation can help investors assess whether diversification is likely to work when they need it most, since stock correlations tend to spike in drawdowns. Exchange-traded products have democratized access to sophisticated strategies, but they also raise suitability and implementation concerns.

Data Points: VIX historical average: around 20 - John Hyatt described the long-run average of the VIX under CBOE’s current methodology. Average VIX in 2017: 11.1 - 2020 was contrasted with the unusually calm 2017 market environment. Average VIX in 2019: 15.4 - Used to show how much more volatile 2020 has been versus recent years. Average VIX in 2009: 31.5 - Referenced as a comparison point for crisis-era volatility. Average VIX in 2008: 32.70 - Cited to show that 2020’s volatility was extreme but not unprecedented. VIX closing high in March 2020: 82.69 - Highlighted as exceeding any closing level even during 2008. Typical S&P 500 peak-to-trough decline in a year: 12% to 16% - Used to remind listeners that meaningful drawdowns are normal, even outside crises. Largest S&P 500 pullback in 2017: 2.8% - Illustrated how unusually quiet 2017 was relative to history. SPX options and VIX-related products: top five by volume - The guests noted these products are consistently among the most actively traded options markets. SPY one-lot volume: over 100,000 contracts a day - John cited growth in smaller, retail-like trading activity in 2020. NASDAQ Composite decline after the dot-com boom: about 80% - Referenced as a historical reminder of how severe drawdowns can be after euphoric periods. NASDAQ Composite rally in late 1999 to March 2000: doubled in about six months - Used to illustrate the speed of bubble-era market moves.

Pivotal Quotes: "“Change is one of very few constants.”" — Kevin Davitt: Explaining the philosophical framing behind volatility and market behavior. "“The VIX is a wonderful forecast that sort of distills the market’s expectations for forward volatility.”" — Kevin Davitt: Defining the index’s practical role for investors. "“Avoiding bad decisions can sometimes be as important as making a series of good decisions.”" — Meb Faber: Summarizing the behavioral case for hedging and sleep-at-night portfolios.

Implications: Listeners should treat volatility as a permanent feature of investing, not an anomaly. Hedging can be useful less for perfect market timing than for preserving discipline, reducing panic, and improving portfolio decision-making during crises.