VIX Traders Bet on Rising Volatility After Year of Calm: Options

Photographer: Tim Boyle/Bloomberg

A trader works on the floor of the Chicago Board Options Exchange (CBOE) in Chicago. Close

A trader works on the floor of the Chicago Board Options Exchange (CBOE) in Chicago.

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Photographer: Tim Boyle/Bloomberg

A trader works on the floor of the Chicago Board Options Exchange (CBOE) in Chicago.

Options (VIX) tied to gains in the benchmark gauge for American stock volatility reached the highest prices in six years last week, reflecting bets that the calm prevailing in equities for the last year won’t last.

A series of calls that appreciate in tandem with the Chicago Board Options Exchange Volatility Index climbed to the highest since May 2007 relative to puts, according to data compiled by Bloomberg. The increase reflects bets that swings measured by the VIX will widen this year after the Standard & Poor’s 500 Index rose 30 percent in 2013 without ever suffering a decline of 10 percent or more.

The intensifying standoff between Ukraine and Russia in the Crimea added to concerns facing global stock investors. U.S. equities completed a rebound last week from a selloff spurred by emerging-market turmoil that erased 5.8 percent between Jan. 15 and Feb. 3, the biggest retreat since June.

“Any time geopolitical risks escalate, especially in a major way -- and we’d say this is a major escalation and a major increase in risk -- you subject global stock markets to increased volatility,” Timothy Ghriskey, chief investment officer at New York-based Solaris Asset Management LLC, which manages about $1.5 billion in assets, said by phone yesterday. “The impact may end up being modest if the situation de-escalates, but right now there is no sign of that.”

Ukraine Crisis

The crisis in Ukraine deteriorated as Russian President Vladimir Putin won parliamentary backing to send troops into Russia’s southern neighbor. Ukraine, which put its forces on combat readiness, said over the weekend an invasion would be “an act of war,” and U.S. President Barack Obama warned Russia not to intervene. The conflict follows a month in which global equities, bonds and commodities rose together for the first time since July and the S&P 500 rallied 4.3 percent to an all-time high after a 3.6 percent decline in January.

Futures on the S&P 500 slid 0.8 percent at 9:15 a.m. in London today. The HSI Volatility Index, which measures the cost of options on the Hong Kong equity gauge, jumped 10 percent, while the Nikkei Stock Average Volatility Index climbed 7. Europe’s VStoxx Index surged 17 percent, the most since January, to 19.56.

Calls predicting a 10 percent gain in the VIX cost 18.2 points more than puts betting on a 10 percent decrease as of Feb. 28, according to three-month options data compiled by Bloomberg. That’s the biggest gap since before the start of the financial crisis.

Market Movement

“It’s the violence of the market’s move that puts the VIX in play,” David Kotok, the chairman and chief investment officer of Sarasota, Florida-based Cumberland Advisors Inc., which manages $2 billion, said in a telephone interview. “When you have events which suggest that there could be a war, you add to the violence of market movement just as you add to the violence in military movement.”

The volatility gauge has declined each year since 2011, based on its annual average, as three rounds of stimulus from the Federal Reserve have helped push the S&P 500 up 175 percent during a five-year bull market. The VIX, which moves in the opposite direction of the S&P 500 about 80 percent of the time, has closed above 20 four times in the past year. That compares with 45 times in 2012 and 135 times in 2011, according to data compiled by Bloomberg.

Last year’s calm is unlikely to be repeated in 2014, according to investors from Dan Loeb, founder of hedge fund Third Point LLC, to Phil Orlando, who helps oversee $376 billion as chief equity market strategist at Federated Investors Inc.

‘Entry Points’

“We believe the market will experience increased volatility this year, and so we will look for opportunities where market draw-downs create attractive entry points,” Loeb said Feb. 27 on a conference call discussing results at Third Point Reinsurance Ltd., a Bermuda-based company that counts on his hedge fund to oversee its portfolio.

Stocks may decline as cold weather in the U.S. causes first-quarter reports on economic growth and corporate profits to lag behind predictions, Orlando said in a Feb. 26 phone interview. Orlando forecasts the S&P 500 will recover from any pullbacks to finish the year at 2,100, matching the most bullish estimate in a Bloomberg survey of 21 Wall Street strategists.

“The middle of the year we think is going to be a little trickier,” Orlando said. “There’s a really good chance for a number of reasons that the market could go through at least a five to 10 percent correction, if not more, at some point over the summer.”

The U.S. economy grew at a slower pace in the fourth quarter than previously estimated, giving the expansion less momentum heading into 2014, revised figures from the Commerce Department showed on Feb. 28.

Puts, Calls

Implied volatility, used to gauge the cost of options, for three-month contracts with an exercise price 10 percent below the VIX was 44.1 on Feb. 28, compared with 62.4 for calls 10 percent above, data compiled by Bloomberg show. The difference in put and call implied volatility rose 36-fold since November 2009.

“The motivation of using VIX options to hedge is that in the event of a crisis, the stock market will likely decline and simultaneously the VIX, the gauge of fear, will rise,” Manish Singh, who helps oversee $2 billion as head of investments at Crossbridge Capital LLP in London, said yesterday. “The hope is that a VIX gain will make VIX calls more valuable, offsetting losses from a stock portfolio.”

Investors may be over-paying for VIX calls after volatility lagged historic averages during the five-year bull market, according to Ryan Detrick, senior technical strategist at Schaeffer’s Investment Research in Cincinnati. The S&P 500 hasn’t posted a decline of more than 10 percent since 2011.

‘Incredible Appetite’

“There’s an incredible appetite to be hedged against higher volatility, and it continues to feed on itself,” Detrick said by phone on Feb. 27. “There’s still so much worry and people wanting to pay up for something that’s insurance, but is it truly as needed as it was six years ago? We don’t think so.”

The S&P 500 recovered from its 5.8 percent drop last month as corporate earnings topped analysts’ forecasts and Fed Chair Janet Yellen indicated the economy was healthy enough to withstand central bank stimulus cuts. The benchmark gauge rallied to an all-time high last week as Yellen said the Fed may change its strategy for reducing stimulus should the economy weaken.

Among the 10 most-owned VIX contracts, seven were bullish, according to data compiled by Bloomberg. There are about 6 million calls on the volatility index outstanding, compared with 2.6 million puts. The ratio of call-to-put open interest has increased 34 percent from a one-year low in June.

“Investors are looking to VIX calls to protect portfolios after the rally last year,” Stephen Solaka, who helps oversee about $130 million as managing partner of Belmont Capital Group in Los Angeles, said in an e-mail. “With the VIX at the lower end of its historical average, I am not surprised there is more demand on the call side.”

To contact the reporters on this story: Nick Taborek in New York at ntaborek@bloomberg.net; Callie Bost in New York at cbost2@bloomberg.net

To contact the editor responsible for this story: Lynn Thomasson at lthomasson@bloomberg.net

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