The Striking Price

Fear Triggers Buying of VIX Calls

STEVEN M. SEARS

Saturday, July 19, 2014

Events in Ukraine and Gaza show that volatility can increase on bad news much faster than it can decline on good developments.

The "Fed Put" may be destined to become the "Yellen call." .

Unfortunately for investors, the call is on the CBOE Volatility Index (VIX), not the stock market. And VIX calls increase in value when the stock market declines.

The potential recasting of the famous Fed Put—named in years past for former Federal Reserve chiefs Alan Greenspan and Ben Bernanke, whose policies seemed designed to support the stock market—follows recent statements from Janet Yellen, the central bank's current chair, that investors are too complacent about risk. This suggests that the days of historically low options volatility, a byproduct of a market grinding higher, are poised to end as the Fed prepares to wrap up its bond-buying program.

"Does 'Don't fight the Fed' mean 'Buy the VIX?'" Steve Sosnick, the equity risk manager for Interactive Broker's Timber Hill market-making firm, asks in a recent note to investors. Indeed, the VIX was mentioned in the minutes of the Federal Reserve's June meeting. The reference was pedestrian but notable because it seemingly marks the first time the VIX has appeared in the minutes. The fear gauge's ups and downs aren't the natural purview of central bankers.

In a section discussing lackluster results for first-quarter corporate earnings, the minutes noted that the "VIX, an index of option-implied volatility for one-month returns on the Standard & Poor's 500 index, continued to decline and ended the period near its historical lows."

This was quite clear to investors, but the Fed's mystery and power subject ordinary pronouncements to intense discussion. "Are they stating the obvious or are they saying something else?" one of Wall Street's top trading strategists wonders.

To be sure, Thursday's events in Ukraine and Middle East were a wake-up call for many investors who were well, complacent, about the stock market's historic highs. The downing of the Malaysian airliner, and the Israeli offensive in Gaza, pushed the VIX up some 32%, its largest one-day move since April 15. The S&P 500 fell 1.18%, its first daily move of more than 1% in 62 trading days.

Earlier in the week, the VIX was around 10, and seemingly blind to the world's woes. But the alarming international news scared some investors, convincing them to pay top-dollar for VIX calls. With the VIX around 13, investors aggressively bought August 13, 14, 15, 16, 17, 18, 19 and 25 calls. Some investors even bought October 18 calls, telegraphing to the market that they are worried stock prices may decline in one of the stock market's most historically temperamental months.

The sudden interest in VIX calls is a big shift from recent trading patterns. Before Thursday, stock portfolio hedging was slow and steady but not enough to move the VIX, which seemed destined to fall into the single digits as the market kept edging higher. Both indexes rebounded on Friday, but the VIX did not erase all of its gain.

THE ONLY PEOPLE WHO really paid attention to the hedging were derivatives analysts, who noted that the index market (not including VIX options) was "skewed" to the put side. This means that, reflecting fear of a market decline, the implied volatility of bearish puts was higher than the implied volatility of bullish calls. But, at the same time, volatility in options on single stocks was relatively muted, and still is, indicating optimism that they will outpace benchmark indexes. This leads contrarians to view the index hedging as a bullish sign.

The impact of last week's events might prove fleeting, or not. But the VIX's violent reaction is a reminder that volatility tends to increase much faster than it declines. The stock market's advance may grind onward, but portfolio protection might not be as attractively priced tomorrow as it is today.

Reprinted by permission of Barron's Online, © 2014 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

The views expressed in the above papers and articles are solely those of the author of the article, and do not necessarily reflect the views of OIC; the information presented is not intended to constitute investment advice or recommendations to purchase or sell securities of any company; and the information presented is based upon particular events that may or may not recur in the future.

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