(Bloomberg) -- Wall Street’s favorite volatility gauge has acted so strangely in this brutal year for equities that a debate has emerged over its soundness. Options experts say there’s nothing wrong with the gauge and the reason is the behavior of investors themselves.

The Cboe Volatility Index, the measure of S&P 500 option costs known as the VIX, usually moves in the opposite direction of the stock benchmark, going up when demand for hedges expands in down markets. This year, however, the two gauges have moved in tandem 26% of the time, the most since 2006. And spikes in the VIX have been muted. It topped out at 36, a lower level than during every bear market since 1990.

The weird behavior has fueled warnings that either the VIX has stopped working as it’s supposed to or that the bear market has yet to run its course. Indeed, one popular protective trade of buying volatility calls, as shown by CBOE VIX Tail Hedge Index (VXTH), has not only failed to hedge losses in 2022 but in many cases created additional ones. 

But derivatives experts say the VIX’s performance is logical. Underlining its unusual swings is a defensively positioned investing community that has shifted their hedging preference to areas like shorting index futures.

“We’ve had a dramatic selloff in the market driven by fears of higher rates and higher inflation — both catalysts that were very much anticipated by investors coming into this year,” said Mandy Xu, head of equity derivatives strategy at Credit Suisse Group AG. “Leverage in the equities market has been taken down significantly by investors de-risking and moving to cash. You don’t need to buy a put option when you’re already in cash.”  

For VIX proponents, the index has generally done as expected in a downturn, trading above its historic average on 94% of trading days — a rate higher than in all but three years since 1990. 

On the other hand, its absolute level hasn’t topped 37, let alone reached heights usually associated with bear-market bottoms. By that analysis, a floor in the stock market probably won’t form until the VIX spikes to 40, Evercore ISI and Strategas Securities suggested earlier this year.

Yet others argue that fear hasn’t shown up in the VIX because paranoid pros already cut their stock holdings to the bone. In Bank of America Corp.’s survey of fund managers, cash holdings rose to 6.1% during the fall, the highest level since the immediate aftermath of the 2001 terrorist attack, while allocation to stocks fell to an all-time low. 

All the defensive positioning means, when stocks tumble, profits from existing hedges are booked and there is no urge to buy insurance. The setup helps explain why the VIX slipped along with the S&P 500 on Dec. 14, even when the Federal Reserve dialed up its hawkishness. 

At the same time, the prevalence of light positioning points to a bigger risk to many investors: missing out on a rally. That’s fed a cycle all year where investors pile into bullish calls to chase gains, leading to a repeated pattern of “stocks up, VIX up.” 

Reactions like this have contributed to VXTH’s flopping returns. Down 27% this year, the tail hedge trade is behind the market by roughly 7 percentage points. 

“Lot of players of the VIX played for big moves to the upside and never got them,” said Matthew Tym, head of equity derivatives trading at Cantor Fitzgerald LP. “Actually, the increase in volatility some days was due to the FOMO trade of buying upside calls as opposed to puts.”

As violent reversals become a feature of 2022’s stock market, options traders are seeking quick profits via contracts with a shelf life as short as less than 24 hours — a category known as zero day to expire, or 0DTE. During the third quarter, 0DTE options made up 44% of the S&P 500’s total trading volume, data compiled by Goldman Sachs Group Inc. show. 

In some ways, the proliferation of those fast-twitch contracts reflects heightened anxiety in the marketplace. Yet none of that is captured by the VIX, which is calculated based on only S&P 500 options expiring 23 to 37 days into the future. 

“‘Volatility’ has changed, in part due to the existence of these short-term options contracts,” said Greg Blaha, an analyst with Bianco Research. “The relationship between the VIX and stock market bottoms today might be different from the relationship seen in the past.”

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