Stocks quoted in this article:
Somebody's bunny thinks the CBOE Market Volatility Index (VIX) is going to see some fireworks in the next few months. This from Nikolaj Gammeltoft on Bloomberg:
An investor paid about $7.95 million for a trade that will pay off if the Chicago Board Options Exchange Volatility Index rallies at least 60 percent by May.
The trader bought 150,000 bullish contracts on the VIX expiring in May with a strike price of 22, while selling the same number of May 30 calls in a strategy known as a call spread, according to New York-based Miller Tabak & Co. The trade cost 53 cents to put on for each contract and it will profit if the volatility gauge rises above 22.53 from the current level around 14, data compiled by Bloomberg show. It has a maximum payoff if the VIX more than doubles to 30.
Should we run for the hills … right after buying some VIX futures?
Not really. This sort of trade happens again and again in VIX. The lion's share of the order flow involves the "public" either buying cheap-dollar VIX calls or cheap-dollar VIX call spreads. This one's just more noteworthy because of the size of the investment.
But size is all relative, of course. If someone's investing $8 million in VIX call spreads that are very likely to never come into play, he hopefully is just risking a small percentage of his portfolio on them. And that's the word on the street on this trade -- that it's a sizable long portfolio behind, and presumably a hedging transaction.
So, call off those VIX futures purchases.
Let's assume this is a relatively actively managed account. I mean, what passive account buys bushels of out-of-the-money VIX call spreads? He doesn't really need VIX to get in the mid-20s or 30, he just needs a VIX rally that's strong enough to generate some interest on the options board. If VIX spikes a bit, VIX volatility will spike, and if VIX volatility spikes, his call spread will give him a ton of ammunition. He can sell VIX futures, sell iPath S&P 500 VIX Short-Term Futures ETN (VXX), sell more VIX calls, sell index puts, buy stocks, et al.
In other words, a position like this gives the owner all sorts of leverage, depending on the timing of the VIX move.
So, for the owner, I'd say it's part insurance policy and part license to get active on market weakness.
Or it's just a guy so confident that he's going to get his brackets perfect that he's got $1 billion coming in from Buffett to play with.
Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.