Frenzy of Volatility Bets Underpin Lowest VIX Since 2007

Below the stock market’s placid surface, a battle is raging over how long the calm will last.

Hedge funds and other speculators have pushed long and short positions in futures tied to the Chicago Board Options Exchange Volatility Index to record highs, according to data compiled by Bloomberg. In listed contracts, demand for protection should the bull market falter has sent the price of bearish puts to a 15-year high relative to calls.

Driving the run-up are investors who have watched the value of stocks almost triple since March 2009 and the price of options as measured by gauges such as the VIX slide to a seven-year low. All the speculation going on, mostly beyond the visibility of individual investors, has the potential to amplify swings in options and may stir the equity market, according to Stephen Solaka, a managing partner at Los Angeles-based investment firm Belmont Capital Group.

“With so many players in the volatility markets, the moves tend to be more sharply up and down,” Solaka said by phone June 24. “It’s just been so schizophrenic. Volatility moves a lot quicker both ways.”

VIX Volatility

An example came on June 24 when a 0.7 percent drop in the Standard & Poor’s 500 Index between 1 and 4 p.m. led the VIX, which derives its price from options on the S&P 500, to rise 1.2 points and finish the day up 10 percent. The increase in the VIX showed people who were betting volatility would remain subdued were trying to unwind that trade, according to Mark Sebastian, founder of Option Pit LLC, a Chicago-based consulting firm.

“When you see the VIX outperform the market in a violent way, that is indicative of a short squeeze,” Sebastian said by phone June 24.

Stocks recovered most of the losses yesterday and the VIX retreated 4.5 percent to 11.59. The VIX increased 0.4 percent to 11.63 at 4:15 p.m. in New York today. Its European counterpart, the VStoxx Index, rose 3.5 percent to 14.8.

Volatility is the Wall Street term that refers to the size of stock swings and the price of options. Its best-known benchmark is the VIX, the stock market “fear index” that is influenced by past equity fluctuations and how options traders expect those fluctuations to evolve. It’s possible to bet on the VIX itself using futures traded on the CBOE Futures Exchange or exchange-traded notes that track the gauge.

Large speculators had a record 356,000 long and short bets outstanding on VIX futures as of June 3, according to data compiled by the Commodity Futures Trading Commission. The number of contracts stood at 340,000, a report last week showed.

Exchange Notes

More than 32 million shares on the iPath S&P 500 VIX Short-Term Futures exchange-traded note have changed hands daily on average this year, more than double the volume of last year. About 41 percent of the shares outstanding in the ETN have been sold short, around the highest level of short interest since April, according to data compiled by Markit Securities Ltd.

There were about 10.1 million puts on the S&P 500 last week before options expiration, the second-highest level since 2011, data compiled by Bloomberg show. Traders own two bearish wagers on the equity gauge for every call, the highest ratio since 2008, the data show.

Wall Street’s willingness to satiate a nearly bottomless appetite among investors for options that protect stocks against losses is raising concern about what happens when the market turns. Options dealing has been a profitable business for the last few years as equities avoided selloffs.

Yield Starved

“The fear is as investors are yield starved, people are looking for ways to extend income and the options market is attracting lots of people selling S&P 500 and VIX options,” Justin Golden, a partner at Lake Hill Capital Management LLC, said by phone from New York. His firm trades options on equity indexes and commodities. “A lot of people are using their bullets and their dry powder on these types of trades. If these go wrong, they can go wrong very quickly.”

Signs the economy is picking up and a conviction the Federal Reserve will maintain stimulus in the event the recovery falters has sent the S&P 500 up 6 percent in 2014 and 190 percent since March 2009. The VIX closed at a seven-year low of 10.61 on June 18.

Sellers of equity derivatives have profited as the market calm allowed them to collect premiums dealing options that later expired without paying off. For 48 days, the S&P 500 has failed to post a gain or loss exceeding 1 percent, the longest stretch since 1995.

Aggressive Protection

An average of about 5.6 billion shares of stock have changed hands each day on all American equity exchanges this month, compared with 7.1 billion in June of last year. The S&P 500’s last decline of 10 percent ended in October 2011.

“In an environment of low volume and with absolute levels of the VIX very low, there’s been an aggressiveness of people putting on index protection,” Scott Maidel, an equity-derivatives money manager at Seattle-based Russell Investments, said in an interview. “Investors who have the ability to use derivatives to hedge are cautiously long.”

Bill Gross, manager of the world’s biggest bond fund at Pacific Investment Management Co. in Newport Beach, California, said his firm has bet against volatility. Gross’s “new neutral” theory forecasts low interest rates and stable global growth.

Selling Insurance

“We sell insurance, basically, against price movements,” Gross, chief investment officer of Pimco, said in an interview June 19 in Chicago at Morningstar Inc.’s Investment Conference. “At Pimco, that’s what we’ve tried in the last four or five weeks.”

Economic growth is bouncing back and the job market is improving, Fed Chair Janet Yellen said in a press conference June 18 following the Federal Open Market Committee’s decision to reduce monthly asset purchases by $10 billion.

Yellen downplayed concerns about asset-price bubbles and incipient inflation in her comments, which came one day after the Labor Department said consumer prices rose in May by the most in more than a year.

“There are enough investors out here looking at all the indicators and signs of inflation and the market keeps going up and up,” said Catherine Shalen, director of research at CBOE, said by phone June 24. “Yellen says things are on course, but there are a lot of signs that things may be overheating.”

Shalen’s Index

Shalen is the creator of CBOE’s SKEW Index, which tracks the cost of options hedging against a plunge in the S&P 500 and rose to a record 143.26 on June 20. The last time the gauge peaked was in December. The S&P 500 declined 5.8 percent at the beginning of this year to a three-month low on Feb. 3.

Another gauge, the Credit Suisse Fear Barometer, which measures the relative cost of S&P 500 bearish options over bullish ones three months from now, has increased 24 percent in June, set to be the biggest monthly increase in two years. The gauge touched a record on June 19.

“When the SKEW Index is steep, people are afraid of some unknowable tail-risk event they can’t predict,” Peter Cecchini, chief strategist and global head of macro equity derivatives at New York-based Cantor Fitzgerald LP, said by phone June 24. “That’s typical when markets are rising and when everything is hunky-dory. They say, I still feel OK, I’m just going to buy deep out-of-the-money options.”

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