Could Coiled Volatility Suggest A Bigger Stock Move Is Coming?

Options bets suggest that traders may be a bit too unnerved about the risks facing the stock market heading into the end of the year. History suggests that such complacency could come back to bite them.

Just a day before the CBOE VIX or Volatility index exploded higher in late July, I wrote about the monstrous rally the market had in June and July, recovering all of its May losses and repeatedly chronicling fresh highs, during which time the VIX had coiled, settling around the 11-12 level, amid investor complacency. With the market having made fresh highs recently, the VIX has moved back into the 11-13 area over recently, and now a storm could be brewing all over again. A similar situation occurred in September as well.

Well, speculator short bets on the Chicago Board Options Exchange (CBOE) Volatility Index futures contracts hit a record high last week, according to data generated by the Commodity Futures Trading Commission. The VIX, which is widely considered to be the best volatility gauge in the market, also reached its lowest level since July on Friday, around 12. It bounced back to trade near 13.

 The Volatility Index, or VIX, an instrument created by the Chicago Board Options Exchange (CBOE), is a real-time market index that represents the market’s expectation of a month period of forward-looking volatility.   In most cases, the higher the volatility, the riskier the security. Derived from the price inputs of the S&P 500 index options, the VIX provides a measure of market risk and investors’ sentiments.

Fear Index

It is also known by other names like “Fear Gauge” or “Fear Index,” as investors, research analysts and portfolio managers generally look at VIX values as a way to measure market risk, fear and stress before they take investment decisions. While muted market fears might seem auspicious for the time being, the VIX could essentially be a ticking time bomb, says Sven Henrich, founder and lead market strategist at NorthmanTrader.

This short positioning in VIX futures came as U.S. stocks hit all-time highs. It is typical when markets are at a record high that traders tend to load up on VIX calls to bet on a pullback, anticipated an explosion in volatility. But this time, they are betting on further stock gains and even lower volatility as the VIX ranges near its low of the year. This optimistic view raises concerns that the market might be ripe for a correction given that trade deal uncertainties continue.

“With a full-blown trade agreement still likely many months out into the future if at all, it’s a little hard for me to take there’s this much optimism,” said Randy Frederick, vice president of trading and derivatives at Charles Schwab. “When you see a huge amount of complacency and excessive optimism especially from certain participants in the market, that’s when you oftentimes tend to get a snapback in the other direction.”

Investors who are wary of a VIX breakout could look into alternative asset allocations such as bond ETFs like the iShares iBoxx Investment Grade Corporate Bond ETF (LQD) or a gold ETF like the SPDR Gold MiniShares (NYSEArca: GLDM) and SPDR Gold Shares (NYSEArca: GLD). 

However, those who believe the VIX will continue to languish or move lower could explore an ETF such as the ProShares Short VIX Short-Term Futures ETF (NYSEArca: SVXY), which tracks one-half the inverse (-0.5x) of the daily performance of VIX futures. Alternatively, they could continue to be long stocks with an ETF like the Invesco QQQ Trust (QQQ) for equity exposure, or the SPDR S&P Pharmaceuticals ETF (XPH), as healthcare has been a top-performing sector.

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