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One Victim of the Market's Stagnation

Are VIX call buyers at risk of a knockout punch?

by 6/2/2014 9:49:21 AM
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The following is a reprint of the market commentary from the June 2014 edition of The Option Advisor, published on May 22. For more information or to subscribe to The Option Advisor, click here.

The blue, green and orange lines on the accompanying chart might as well have been produced by a 6th grader asked to draw 3 lines of any shape (one in each color) across the page, with the only "rule" being that none should rise above the horizontal line labeled "+4%" nor fall below the horizontal line labeled "-6%." And then it turns out the student "made a mistake" in drawing the orange line by allowing it to wander too far downward early on.

Year-to-Date Daily Chart of DJI, SPY, and IWM

This explanation for what appears on this chart would actually have made a lot more sense to me at year-end 2013 than if you had instead told me it represented the year-to-date 2014 changes (as calculated daily on a closing basis, through May 22, 2014) relative to their 2013 closing prices for the two "headline" market benchmarks (the Dow Jones Industrial Average and the S&P 500 Index -- as represented by the SPDR S&P 500 Trust [SPY], its actively traded ETF) and the most widely followed measure of the price action of the smaller caps (the Russell 2000 Index -- as represented by the iShares Russell 2000 Index [IWM], its actively traded ETF). Because to have guessed that not a single one of these 3 instruments would have moved at any time over this period by more than 6% in either direction (except for one very brief period for one of the three) from its 2013 closing price, and that in late May all 3 would be trading within 3% of their 2013 closing price, would have defied credulity.

In fact, the only "credulity" to the way the 2014 stock market has played out so far is in itself highly ironic. Because when viewed in the proper context, this "lack of volatility" (actually more akin to "lack of a pulse") in the 2014 stock market appears to me to be the final nail in the coffin for those who had followed a strategy that had -- despite its innocent-sounding purpose -- attracted mania-like levels of participation from even the most sophisticated money managers and hedge funds. I think you've seen me refer to this as "the protection trade," for which call options on the CBOE Volatility Index (VIX) were the "weapon of choice" and whose objective was to protect against a crash in the stock market by betting on the sharp increases in volatility that so often accompany market plunges.

Not only did those who stick to this "hedging strategy" experience no market crashes, but market volatility -- with a few interruptions here and there -- proceeded to decline inexorably, thus causing the expiration of their various VIX call options to become a monthly rendezvous with death. And while open interest on the VIX call options is still huge (and some open interest records were set this year), VIX call volume appears to be drying up, as has the new money for this trade best described as "a solution looking for a problem."

Presumably, those managers who have now been deprived of their "VIX toys" and who were truly "bears disguised as fully invested bulls" have been expressing this view the "old fashioned way" -- by cutting back on their market exposure. And this activity has, I am sure, contributed to the supply every decent rally in the making has encountered in 2014.

But I believe the real knockout punch has yet to be delivered to those hedge fund-type bears who had decided to become "pretend bulls" by taking positions in "VIX hedges" until too much cash had been incinerated for almost anyone's constitution. The first blow came from volatility that refused to "pop." The final blow to those who can barely tolerate long positions in the market will come from a stock market that refuses to suffer a decent pullback -- until their opportunity cost for being under-invested will top even the money that was incinerated on VIX calls. And, yes, it will be at that point of maximum pain that it will, in fact, truly become time to consider "hedging volatility."


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