If you’ve been paying attention to the market lately, you will have definitely noticed an uptick in volatility. The VIX, the most popular measure of volatility, spiked on several occasions over the last two weeks. Plus, it remained elevated (relative to recent months) even on less volatile trading days.
You can see from the chart, this is the first real action we’ve seen in the VIX for quite some time. Of course, as I write this, the aforementioned volatility index is dropping down to pre-spike levels. However, we have several reasons to believe volatility is going to stick around for the coming weeks.
First off, the debt ceiling is fast approaching and there’s far from a political consensus on how to proceed. A major government shutdown is one thing the financial markets definitely do not appreciate. If the ceiling isn’t resolved or extended, we could see a spike in volatility and a selloff in stocks.
Of course there’s also North Korea, a country that enjoys lobbing nuclear missiles all over the Pacific. There’s the aftermath of Hurricane Harvey to consider. And let’s not forget, the current White House likes to stir things up quite a bit – so you never know what may be coming.
Here’s the thing…
A size trader recently made a massive bet on rising volatility. And, it could be a signal that volatility isn’t going to dissipate anytime soon.
Specifically, the trader purchased 50,000 VIX December 20th 15 calls for $2.25. To break even on the trade, the VIX would need to be at 17.25 by December expiration. That’s a far cry from today’s 10 level in VIX.
You may be thinking, well that’s not all that unusual for a hedge to use out-of-the-money calls in VIX. Even 50,000 calls isn’t out of the ordinary since institutions like to use the VIX to hedge long portfolios.
However, there are couple differences with this trade which cause it to stand out. First off, December is a “back month” in VIX. It’s not one of the nearest three tradable months. That in itself is unusual as most large VIX trades happen in the near months. Hedgers (and speculators) are normally more concerned with what’s around the corner, not down the block.
The other point to consider is the trader spent a massive amount of cash on this trade. The calls cost $11.25 million to purchase. The call buyer didn’t even bother to use a call spread to reduce the premium. Once again, this is either a gigantic hedge or an insane amount of speculation. Either way, the trade should not be ignored.
It’s possible this trade is signaling higher volatility will be occurring before the end of the year. And, the potential volatility increase may be substantial or long-lived (in relative terms).
As always, I have a cheaper trade recommendation for those who may be worried about higher volatility in the coming months. I like the idea of using December so you’re protected through the end of the year, but instead of outright calls, let’s look at a call spread.
The December 14-19 call spread costs only about $1. That means you break even at 15 and have the chance to make $4 if the VIX goes to 19 or higher. The 1 to 4 cost to max profit ratio is a good one for a call spread in VIX. Plus, the VIX rarely goes above 19 these days, so you’re likely not giving up much in the way of upside.