By Saqib Iqbal Ahmed
NEW YORK (Reuters) - A muted response by Wall Street's main gauge of investor fear to the drubbing U.S. stocks took earlier this week has left many investors wondering if the VIX index (VIX)was caught napping.
Market participants say that a healthy level of hedging activity going into the sell-off and the recent upward bid for Treasury prices explains the volatility index's relative calm.
U.S. stocks plunged on Wednesday, with the S&P 500 (SPX) dropping 3 percent on the day. But the VIX, which moves in the opposite direction, rose only 4.5 points. Equities staged a rebound on Thursday, and volatility expectations retreated.
"While the VIX has gone up it has not gone up as much as one might think," said Eric Metz, chief investment officer at SpiderRock Advisors LLC in Chicago.
Rarely over the last 10 years has the VIX been so slow to react. For example, the fear gauge jumped nearly 13 points when the S&P 500 fell about 4 percent on Aug. 24, 2015, and it rose 10.5 points after the S&P lost 3.9 percent on May 20, 2010.
On average, over the last decade, a decline of 3 percent to 4 percent in the S&P 500 index has led to a 6-point jump in the VIX.
"A cynic might say that the VIX is asleep at the wheel," said Michael Purves, head of equity derivatives strategy at Weeden & Co in New York.
Well-hedged investors may be the explanation, said Metz.
For S&P 500 options, there are nearly 2 puts open for each open call, a level of defensive positioning that is close to the highest it has been since the volatility shock in February of this year, according to Trade Alert.
"If people are well-hedged going into these events, then the need to put on protection during them is lessened. When you do get the sell-off the panic element is muted," said Metz.
The recent strong bid for Treasuries may also help to explain the muted VIX, said Purves.
U.S. Treasury yields, which move in the opposite direction of Treasury prices, fell to three-week lows on Wednesday.
A somewhat concerted slump in both equities and Treasuries earlier this month had spooked investors who rely on the typically inverse relationship between stocks and bonds to act as a diversifier for their portfolios.
With that traditional relationship back in play on Wednesday, investors had lesser reason to panic and drive up the VIX, Purves said.