by Jan-Patrick Barnert
Hedging stock-market risk by buying VIX calls has become such a popular trade that it could turn into a destabilizing force, some strategists warn.
More than 1 million call options on the Cboe Volatility Index changed hands on Tuesday, the sixth time this year that volume was this high. The most traded were contracts with strikes of 24 and 25 points expiring in March — after the next Federal Reserve rate decision and through the end of the bill that averted a US government shutdown in December.
These fresh trades are putting option dealers “extremely short VIX gamma,” Nomura cross-asset strategist Charlie McElligott wrote in a note this week. He estimates that dealers have to buy vega, or volatility, of about $150 million for every 10-point gain in volatility, the highest reading in Nomura data going back six years.
That means the market is getting ready for a potential volatility squeeze within US equities, creating the backdrop for a bigger de-risking event, according to McElligott. While the market isn’t there yet, he called the positioning a “hypothetical-yet-spooky backtest” on what could happen should a volatility shock occur.
“If VIX rallies toward those strikes as we approach March expiration, volatility of volatility would likely blow higher again on dealers and market makers reaching out into buying VIX futures to stay hedged,” he wrote.
McElligott’s warning comes as overall stock-market positioning remains bullish. The S&P 500 Index closed at a record high Wednesday, hedge fund and leveraged exchange-traded fund exposure is extended, mutual funds’ cash levels are low and demand from retail investors is high.
Last week, Goldman Sachs Group Inc.’s Scott Rubner noted that a bearish trade is looming as the supportive flows could vanish come March. Meanwhile, a measure suggests that investors are starting to increase tail-risk hedging, with potential shocks that could stem from tariffs to German elections and artificial intelligence developments.
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