Stories about equity volatility plunging to “historical lows” have been ubiquitous in the financial press recently. When accompanied by references to above-average valuations and “over-heated” markets, the implication seems to be that investors should rush to buy protection via equity puts or volatility index options, presumably because some decline in equity markets (and thus increase in volatility) is just around the corner. Any investor considering such a purchase needs to assess the likelihood and predictability of such an event—i.e., how often stock indexes make sharp up or downward moves and whether valuations can help predict such moves—and, assuming these events are somewhat predictable, the attractiveness of options pricing. Looking at the historical data and current options pricing, investors today will likely not be well served using options to hedge equity portfolios against sharp downward moves.

Stock returns are positive far more often than they are negative. Since the inception of the MSCI US equity index, the percentage of positive rolling cumulative one-, three-, and twelve-month returns is 61%, 67%, and 77%, respectively. And significant moves in stocks are more likely to be up than down. For example, while the percentage of rolling six- and twelve-month nominal returns greater than 10% is 33% and 56%, respectively, the percentages for rolling returns below -10% are just 8% and 13%, respectively. This dichotomy is even more true for bigger moves—only 2% of all rolling six-month equity returns are below -20%, versus 10% of rolling six-month returns greater than 20%. Investors hoping to time large drawdowns should understand they are fairly rare.

While acknowledging the odds may be stacked against them, some investors will ask whether the odds can be enhanced by buying options when equity valuations look stretched. Unfortunately, historical data for hedgers are not encouraging either. The historical predictive power (measured for example via linear regressions) of starting valuations on subsequent short-term returns is very low. For example, looking at short-term metrics like trailing price-earnings multiples, there is virtually no relationship between starting multiples and subsequent one-, three-, and twelve-month returns. The same is true for normalized metrics. The reason for this is that stocks tend to move over extended cycles and often remain over- or undervalued for substantial amounts of time before moving back down to (or up to) “fair” or average valuations, which in and of itself speaks to the difficulty (and cost) of trying to hedge against near-term movements.

Putting aside historical returns and the predictive power of valuations for short-term returns, it still seems intuitive that buying options when volatility is “cheap” makes sense. However, discussion in the financial press about volatility tends to focus on the VIX, a Chicago Board Options Exchange index that tracks average implied annualized volatility from different one-month options on the S&P 500. The VIX has declined around 16% year-to-date, and traded around 11.6% on June 30, low by historical standards but not unprecedented; the VIX was at similar levels in 2005–06 and in the mid-1990s. But two points are more relevant. First, given the rarity of sharp short-term declines (one-month or three-month) and timing/implementation issues if done on a one-off or ad hoc basis, investors would obtain better protection by continuously buying longer-dated put options. However, longer-term volatility is more expensive; for example, implied twelve-month volatility today is around 25% higher. Second, implied volatility (which drives options pricing) is only “cheap” if it turns out ex post to be less than realized volatility, and this very rarely is the case. Over the past three years, average implied six-month volatility on the S&P 500 has been 17.7% but realized volatility has been 15.7%; the same is true of different volatility tenors.

Given all this, investors historically have not been well served by buying equity puts or options on volatility indexes. While there is some evidence to show that buying put options when valuations are at extreme levels is marginally more successful, US stocks are not at these levels today. In any environment, aside from the arguments above, many institutions would face implementation challenges such as how to fund option purchases (do you have to redeem from high conviction managers to raise option premium?) and when to stop buying options (assuming these purchases are part of some type of hedging program). Investors whose circumstances make them especially vulnerable to severe drawdowns may still benefit from buying protection in the form of options, but for most investors with long-term time horizons, defensive hedges through options will subtract from performance.

Wade O’Brien is a Senior Investment Director on the Cambridge Associates Global Investment Research team.