Another Smart-Money Signal on a Lower VIX?

After the recent VIX spike, put activity on the volatility gauge exploded

by Bernie Schaeffer

Published on Mar 6, 2018 at 7:42 AM
Updated on Jun 24, 2020 at 10:16 AM

During calendar year 2017, the Cboe Volatility Index (VIX) averaged a daily reading of 11.09 -- considerably lower than its daily average of 14.40 over the period from January 2013 to December 2017. However, through the first two months of 2018, VIX averaged a daily reading of 16.48 -- about 14% above its aforementioned five-year average.

The response from options traders to the recent VIX ramp might surprise you, though. The VIX 20-day buy-to-open call/put ratio had crashed as low as 1.66 by the middle of last week (per the first chart below), according to Schaeffer's Quantitative Analyst Chris Prybal -- the lowest such reading since Nov. 29, 2016. The drop in this ratio was driven by both a drop-off in call buying and a simultaneous jump in put buying... although "jump" undersells the magnitude of the recent spike in buy-to-open VIX put volume.

More to the point, 20-day cumulative buyer-driven VIX put volume just topped 1.5 million contracts for only the second time since we've been tracking the data. The only prior incursion on the 1.5-million marker occurred between Sept. 3 and Sept. 21, 2015 -- a time frame that immediately followed a similarly steep incline in the VIX, it's worth mentioning.

Now, put open interest on the "fear index" stands at 3.87 million contracts, which ranks in the near-peak 98th percentile of its annual range, per Trade-Alert. In contrast, current call open interest of 8.15 million contracts registers in the somewhat tepid 46th annual percentile.

On its face (i.e., setting aside for now the possible caveat of hedging activity), this sudden and seismic shift in VIX options activity (in the form of sharply increased put buying coincident with significantly decreased call buying) indicates traders are betting on a decline in the volatility index, and in fairly massive numbers, fresh on the heels of its catapult to two-year highs -- what you might call "fading" the VIX rally. And the "predictable" contrarian reaction to widespread bearish speculation in the face of a breakout technical performance by a given instrument would be generally bullish.

But the VIX is not an "underappreciated" mid-cap chip stock, or a small-tech biotech in the throes of a short-covering rally. It's a statistic that has historically tended to mean-revert after sudden excursions higher or lower. So in that regard, the recent put buyers are simply expressing the perfectly reasonable expectation that a reversion to the mean by VIX is likely imminent. And the last time around, this strategy turned out to be the "smart money."

After the fall 2015 crest in VIX put buying, Prybal's analysis shows the volatility index (fresh off what was, at the time, a six-year peak) declined significantly in the ensuing weeks and months. One week after 20-day buy-to-open VIX put volume eclipsed 1.5 million contracts, the index was down 4.84%. Two weeks later, VIX was off 17.45%, and eight weeks later, the decline stood at 42.95%. By the time half a year had passed, VIX had recovered from the worst of those lows -- but not by a lot, with the 26-week return arriving at a loss of 34.79%.

Looking at "anytime" returns for perspective, Prybal shows the VIX (since Sept. 3, 2015) has averaged gains over periods of one week (+1.58%), two weeks (+2.22%), four weeks (+3.27%), and eight weeks (+3.62%). The average 26-week return, meanwhile, is a drop of 8.43%. Yes, that's less than one-quarter the size of the decline realized over this same time frame following the 2015 VIX spike.

So if the 2015 "VIX explosion" is any precedent, the recent wave of "bearish" speculation on the volatility gauge could ultimately prove profitable for put buyers. Worth pointing out specifically is that, in the example described above, the VIX decline played out in a manner that was not only substantial, but prolonged -- meaning there's likely still an opportunity to trade this latest mean reversion.

vix 20-day call put ratio since 2013

vix 20-day call and put volume since 2015

Subscribers to Bernie Schaeffer's Chart of the Week received this commentary on Sunday, March 4.

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