From the Top

How the 'Smartest Guys in the Room' Flubbed the Volatility Trade

What we can learn from VIX call volume spikes

by 9/3/2013 1:28 PM
Stocks quoted in this article:

The following is a reprint of the market commentary from the September edition of The Option Advisor, published on Aug. 22. For more information or to subscribe to The Option Advisor, click here.

"In the Russell 3000 Index, the 100 most heavily shorted stocks are sharply outperforming the average returns of stocks in the index ... The shorted stocks are up by an average of 33.8% through August 16, versus 18.3% for all stocks in the index."
-MarketWatch, "Short sellers suffer worst losses in a decade," Aug. 21, 2013

"Lloyd Blankfein's minions (at Goldman Sachs) found that, through mid-August, not even 5% of these guys (hedge funds) had beaten the S&P 500 in 2013."
-MarketWatch ("The Tell"), "Average hedge fund up 4% this year vs. S&P 500's 20% rise," Aug. 21, 2013

With the huge preponderance of short selling activity in this market generated by and for the hedge fund contingent, it is easy (and proper) to conclude that the so-called "smartest guys in the room" are in fact having a very disappointing year, due in large part to the severe beating they have sustained on their bearish bets. Put another way, their attempt to mitigate what they saw as the very real risk of being heavily exposed to the long side of the market (by simultaneously running a book of short positions) blew up on them in a big way. (There are a number of tangible reasons why this blowup on the short side should be of no surprise, but that's for a different commentary.)

But despite the hedge they theoretically should have achieved from running a long/short portfolio rather than by operating "long only" (an approach they have much derided over the years), many hedge funds were not content to "let it ride" with their long positions and the ever-present exposure to market declines. So they ramped up their hedging to include all manner of volatility-based instruments that would (theoretically) allow them to profit from market pullbacks and perhaps even be heroes should the ever feared "Great Crash" arrive. And as you probably already know, thus far the net effect of volatility-based hedging has been volatility-based losses, and a compromise of their total returns on the long side.

If you regularly follow our Todd Salamone's razor-sharp weekly market analysis in his Monday Morning Outlook, you are familiar with the fact that we use as "shorthand" for measuring the level of volatility-based hedged exposure the total open interest in the options on the CBOE Volatility Index (VIX). And the accompanying chart (click to enlarge) tells a pretty amazing story: Total VIX call open interest surged from a 2.4-million contract peak in November 2011 to a peak of 7.7 million contracts in March 2013. (And while total VIX call open interest did taper off to a 5.4-million contract peak in July, this taper has been almost completely reversed with the renewed surge to a 7-million contract peak this week when the August VIX options expired.)

VIX Daily Open Interest since August 2011
Chart courtesy of Trade-Alert

I would be remiss if I did not also point out that while this VIX-based hedging activity (to protect against market declines) has tripled since November 2011, the S&P 500 (SPX - 1,656.96) has marched steadily higher to the tune of a 40% gain -- from about 1,200 in late 2011 to a recent peak just north of 1,700. Certainly the explosion in the so-called "portfolio protection" trade that accompanied such a strong market rally is a source of some glee among us contrarians and a great illustration that bull markets accompanied by widespread skepticism tend to have remarkable staying power. But there are some more specific takeaways, and for this I will close by quoting from a recent exchange I had with Todd Salamone:

I think growing VIX call open interest is actually a sign of an institutional community that is growing more bullish, but that is in a constant state of 'caution' and thus the strong desire to be hedged. This is why I think the market's best periods occur when VIX call open interest increases from relatively low levels (November 2011), and poorer periods occur when VIX call open interest falls from extreme highs (March-July 2013.) But there are periods when VIX call open interest grows and the market does little, which I think is speculative activity at work betting on a big volatility pop (such as just ahead of the 'fiscal cliff').

From here, I think the bulls want to see VIX open interest grow slowly, as I think it is a sign that the hedged heavy-hitters are in accumulation mode. And if the VIX is at low levels, you can almost bet the ranch that they are way underweight equities, giving them more cash to deploy to the market. Also, if VIX call open interest is growing, it may be because the hedge funds are in short-covering mode. So, as they remove short positions, they simultaneously buy VIX calls as their hedge.


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