VIX Options Show Biggest Bets on Stocks Retreat Since June 2008

By Jeff Kearns and Lynn Thomasson
Jan. 25 (Bloomberg) -- Traders are piling into bets that the biggest sell-off in U.S. shares since March will increase stock market volatility, pushing call options on the VIX Index to the highest level in 19 months.
Outstanding contracts speculating on an advance in the Chicago Board Options Exchange Volatility Index climbed to three times the number of wagers for a drop, the highest ratio since June 2008, data compiled by Bloomberg show. The VIX, which measures the cost of using options as insurance against declines in the Standard & Poor’s 500 Index, moves opposite to equities more than 80 percent of the time.
Investors are doubling down after some of last week’s most- traded options rose 75 percent on Jan. 22. They’re speculating President Barack Obama’s proposals to limit risk-taking by banks and signs China will rein in growth will extend the S&P 500’s drop after it fell 5.1 percent in the last three days.
"There is higher probability that we will see moves to the downside," said Tim Freeman, head of U.S. equity derivatives sales at Capstone Global Markets LLC in New York. "The changes that are being proposed to the banking industry, the political motivations and the policies that are being considered are game changers and they will move this market in a big way."
The VIX jumped 55 percent to 27.31 in the last three sessions, the biggest surge since February 2007, as demand rose for options to protect equities from losses. Futures show traders are betting it will remain above 25 for six months after averaging 20.29 over its two-decade history.

Put-Call Ratio

Open interest, or the number of existing contracts, for calls on the VIX is 1.66 million, compared with 524,108 puts.
Calls give the right without the obligation to buy a security at a set price and date, while puts convey the right to sell. VIX options expire two days before the third Friday of each month and are linked to futures on the index.
More than 388,000 VIX call options changed hands Jan. 22, the most in a month. The volume was almost triple the four-week average and three times the number of puts.
"Whether we’re going to have a new bear phase is uncertain," said Lawrence Creatura, a Rochester, New York-based fund manager at Federated Investors Inc., which oversees $390 billion. "The political environment changed pretty dramatically during the week."
Stocks in the U.S. have retreated two straight weeks, pushing the S&P 500 down 4.7 percent to 1,091.76. The index is still up more than 61 percent from its low in March, boosted by record low interest rates and more than $8 trillion lent, spent or guaranteed by the U.S. government to end the recession.

Bank Shares

Financial stocks in the S&P 500 tumbled 5.2 percent last week, the most in almost three months, after Obama asked Congress to bar banks from running proprietary trading operations solely for their own profit and sponsoring private- equity and hedge funds. Raw-material producers in the index collectively fell 6.4 percent amid speculation China, the world’s fastest-growing major economy, will boost interest rates to prevent growth from igniting inflation.
Stocks retreated as some legislators said they would oppose granting Ben S. Bernanke another term as head of the Federal Reserve. Of senators who released statements or were contacted by Bloomberg News over the past two days, 30 said they would vote for Bernanke or were leaning in his favor, while 16 were opposed or leaning against him and 31 were undecided. The S&P 500 fell 3.9 percent last week for the biggest loss since October.

VIX Futures

VIX futures for March added 6.8 percent, the most since they started trading in August, to 25.15 last week. June futures rose 4.1 percent to 25.35. Each future has a contract size of $1,000 per volatility point, which means a 25.00 future costs $25,000.
The surge in the benchmark index for U.S. stock options prices exceeded the 33 percent three-day gain for the European VStoxx Index on the Dow Jones Euro Stoxx 50 Index.
The VIX had its biggest annual drop ever in 2009, falling
46 percent, as the smallest stock-market swings in two years reduced the value of equity derivatives. The gauge is still down
66 percent from a record 80.86 in November 2008.
"The market is taking a break from the huge run it has had," said Bob Doll, who oversees $3.2 trillion as chief investment officer for global equities at New York-based BlackRock Inc., the world’s biggest asset manager. "I don’t know if we have seen the end of this pull-back and I wouldn’t put all my dry powder in."

25 is usually the sweet spot for the VIX. Anything over that we usually heavy selling activity. I will be very cautious trading equities this week. I will probably only trade Oil and Nat Gas. However, once the dust settles, this could be a great opportunity to jump back in.