Even as the post-election rally has sent Wall Street to record highs, demand for using options to hedge against the risk of a stock market crash is rising.

Trump's victory earlier this month dispelled investor concerns about a potentially contested election result, pushing the S&P 500 to a record high. The CBOE Volatility Index, or VIX, a gauge of investor fear, closed near a post-election low of 14.10 on Tuesday.

However, several gauges of protection against extreme market volatility are rebounding, such as the Nations TailDex Index (TDEX) and the CBOE Skew Index (SKEWX). While the gains in these indexes do not necessarily mean that investors are expecting a catastrophic event, they suggest that investors are more cautious in the face of several major risks, including a possible rebound in inflation triggered by global trade turmoil next year.

Those risks first surfaced late Monday when Trump pledged to impose steep tariffs on Canada, Mexico and China, providing concrete evidence of how he would implement a campaign pledge that could spark a trade war.

While U.S. stocks largely shrugged off the comments, Trump’s rhetoric recalled market volatility caused by his trade moves during his first term, providing a case for portfolio hedging.

Amy Wu Silverman, head of derivatives strategy at RBC Capital Markets, said investors are guarding against so-called fat-tail risks, referring to a higher expected probability of extreme market moves.

“While investors are still broadly long stocks, the likelihood of extreme moves in stocks has increased,” she said. This is partly due to higher geopolitical risk premiums and, of course, potential policy risks after Trump returns to the White House, including tariffs and other measures.

The Nations TailDex index, which measures the cost of hedging against big swings in the SPDR S&P 500 ETF Trust based on the options market, has risen to 13.64, double its post-election low of 6.68 and is now higher than it has been 70% of the time over the past year.

The Skew index, another gauge of the market's view on the potential for extreme market swings, closed at a two-month high of 167.28 on Monday.

VIX call options, which protect against a market sell-off, also show some demand for protection against “tail risk.”

The VIX three-month call option skewness, a measure of the strength of demand for these contracts, is hovering near its highest level in more than five years, according to analysis by Susquehanna Financial Group.

“The market in general is pricing in an 80-95% chance of fairly low volatility, which is why the VIX is relatively low, but there is more tail risk being factored in,” said Chris Murphy, co-head of derivatives strategy at Susquehanna.

Maxwell Grinacoff, equity derivatives strategist at UBS, said Trump’s tariff pledge on Monday was the kind of risk that investors might worry about encountering again in the coming months.

“It’s giving people a reason to start hedging again,” he said. “You’re already seeing more signs of downside hedging coming back again.”

Investors are also grappling with uncertainty about how much the Federal Reserve will cut interest rates in the coming months. As officials face a stronger-than-expected economy, easing monetary policy too much could spur a rebound in inflation. The Fed holds its last monetary policy meeting of the year on Dec. 17-18.

The Russia-Ukraine war and the conflict between Israel and Hamas could also add to market volatility.

UBS’s Grinacoff said next year could resemble 2018, when stocks hit new highs at the start of the year but then slipped as headlines about trade and tariffs hurt growth expectations and volatility rose across asset classes.

Investors’ demands for downside protection “make sense to me,” he said.

Article forwarded from: Jinshi Data