How to Hedge Against a Potential VIX Pop

Ahead of Friday's potentially market-moving central bank meeting, traders may want to hedge long stock positions by buying VIX calls or going long VIX futures

Senior Vice President of Research
Aug 22, 2016 at 9:30 AM
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 "… What stands out is the massive call open interest at the overhead 220 strike, which boasts more than 600,000 open call contracts in the 8/19 and 8/26 series (394k in the 8/19 series and 231k in the 8/26 series). Note that volume of more than 200,000 contracts occurred in the 8/26 220-strike options, so there may have been liquidations. Additionally, call open interest is heavy at the 218 strike too, which also presents a headwind in the immediate days ahead ... [T]he more likely scenario is the SPY being susceptible to a drift lower over the course of the week to about the 217 strike ... The smaller possibility is the sharp rally up to and through the 220 strike."
- Monday Morning Outlook, August 15, 2016

Last week, I took an in-depth look at how standard August expiration would likely play out, just one year after August 2015 standard expiration week scared many investors, who witnessed a near-5% plunge in the SPDR S&P 500 ETF Trust (SPY - 218.54). From an options-related perspective, I didn't see a lot of risk of August 2015 repeating itself -- although I did expect a decline, speculating that market headwinds would prevail as long S&P futures positions associated with expiring call open interest overhead were unwound.

By mid-afternoon Monday, it appeared as if the "smaller possibility" sharp rally though the 220 strike was becoming a stronger possibility. But, it is likely that profit-taking once again set in as: 1) SPY $219.50 represented a 10% advance from the post-"Brexit" late-June closing low of $199.60; and 2) the iShares Russell 2000 ETF (IWM - 122.94) peaked just 19 cents below $123.88, which coincides with a 10% gain from the 2015 end-of-year close at $112.62.

It is quite possible that a "profit-taking" or "hesitancy-to-buy" mentality kicked in as these major exchange-traded funds (ETFs) hit round-number percentage levels above a key low and last year's close, setting up a decline into last week's SPY low at $217 -- which we suspected could mark a low for the week, based on the expiration-week open interest configuration analysis that was presented to you.

spy 30 minute august 22

With expiration week behind us, now what? A lot of talk has focused on the lack of movement in the market this month. In fact, last week, the historical volatility (HV) reading on the S&P 500 Index (SPX - 2,183.87) was in single digits for the 15th consecutive day, the first time a consecutive streak like this occurred since December 2014. Moreover, the CBOE Volatility Index (VIX - 11.34) hit a multi-year closing low on Friday, as the VIX followed HV readings lower and option traders factored in relatively low volatility in the days and weeks ahead. 

This is especially interesting from the perspective that central bankers are scheduled to meet in Jackson Hole, Wyoming, later this week -- an event that will closely watched by traders. With the potential for this to be a market-moving event, the risk now is very similar to that which we observed in June, ahead of a Federal Open Market Committee (FOMC) meeting and the "Brexit" referendum.  

Specifically, large speculators have a massive short position in VIX futures, according to the latest Commitments of Traders (CoT) report. These market participants had a large short position in early June, just days ahead of a sharp, short-lived doubling in the VIX over a three-week period. Additionally, to the extent that VIX calls are used to hedge these short positions, there are now only 3.8 million calls outstanding, which compares to a 52-week call open interest low of 2.6 million soon after January 2016 VIX expiration and a 52-week high of 7.5 million prior to April expiration.

So, as in June, the biggest risk we see is on the volatility front, given large speculators' massive short position on VIX futures ahead of a key event later in the week. If you are looking to hedge a long position in equities, look to do this by going long VIX futures or buying VIX calls. And, for what it is worth, while in June the SPX was battling the round 2,100 level, now the round 2,200 level lingers just overhead.

Large speculators - extreme short position
commitment of traders cot short positions august 22

While a volatility pop is a risk, the recent long period of single-digit HV suggests history is on the side of short volatility players, at least for the next two months. This is why we recommend a long volatility position as a hedge, as we are not suggesting that you reduce your long equity positions. 

For example, per a study our Senior Quantitative Analyst Rocky White did last week, when the SPX hits single-digit historical volatility readings 15 days in a row, the signal produces lower standard deviations of returns in the next month and two months, relative to the at-anytime readings. In other words, history suggests a low-volatility environment may be here to stay for a couple more months.

spx historical volatility august 22

Continue reading:

Indicator of the Week: Does a Low VIX Mean it's Time to Buy Options?

The Week Ahead: Attention Turns to GDP; Plus, Retail, Solar Earnings

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