Schaeffer's Trading Floor Blog

Reader Mail: A Follow-Up to the $18 Million VIX Trade

Speculating on the bearish side of excessive VIX call volume

by 1/30/2014 7:20 AM
Stocks quoted in this article:

I was having a Twitter conversation with a friend in regards to that gigantic CBOE Volatility Index (INDEXCBOE:VIX) call trade we noted yesterday, and he asked me this:

u said "…VIX call activity is bullish for the market." If you buy call don't you want vol to increase and market decrease?

That's very true, which leads to the question of why, in my humble opinion, excessive VIX call volume is bullish for the overall market. So let me try to clarify my point of view on this.

Every options trade is a zero-sum game. One side wins, the other side loses, and theoretically, it should have no impact on the market. In the case of VIX calls, the owner can theoretically sell VIX "something" when volatility rallies, while the seller will have to buy VIX "something" in order to defend his capital. That should offset, and ergo, there's no impact.

The reality is, their experience is not as simple and inversely symmetrical as the above would indicate. As countless psychological studies have shown, we humans react very differently to wins and losses. We hate our losses way more than we enjoy our wins. It manifests itself in the market as a whole in that we see market declines often accompanied by explosive volatility, whereas rallies can go on and on at very low volatility. On the level of one simple trade and position, it manifests itself by the loser of the trade taking more aggressive action than the winner of the trade, who will likely hedge much more slowly, if at all. Multiply that dynamic by countless positions and trades, and we get the effect of selling begetting more selling that we so often see in ugly markets.

Options shorts also do not have a perfectly inverse experience to options longs. An options short has open-ended loss potential. Let's look at that $18 million VIX call sale again for a sec. If that was the seller's only position, and the volatility market started exploding, the trader would surely have to jump in and defend his position by some combo of:

  1. selling stock futures,

  2. buying VIX futures,

  3. buying S&P 500 Index (SPX) puts,

  4. buying VIX calls, and

  5. screaming.

One reason a trade like that isn't enormously bearish for the market is that it's likely the order was initiated by a gigantic trading desk or fund, and it was hedging a pre-existing position or exposure of some sort. Otherwise, it's an insane trade.

Another reason is back to that zero-sum game. There's $18 million plunked down on cheap VIX calls that provide terrific insurance for the owners against a volatility explosion. They're not under pressure to act, as their potential losses are defined and at the moment, and they hold the better-looking hand. But it's out there, and if the order initiator is not under pressure (because presumably he's not naked short the VIX calls), then we can expect someday, some way, that the VIX call owners will provide a modicum of selling pressure on volatility.

Bottom line is that more often than not, the options-selling side works better than the options-buying side, so more often than not, options buyers are the ones who ultimately defend their positions and provide support on the margins. At times though, the option sellers get squeezed, and those squeezes are quick and violent and they pile on to the volatility lifts and market dips that we periodically see (like now).

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.

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