VIX: Bite the Bullet
In the wake of the recent six-week sell-off, I think the one thing that has been more fascinating than anything else is how unfascinated the market is by this activity. Since the beginning of June, the market has sold off about 85 points. That is more than 6%. In that period of time, implied volatility has increased less than 3%. If the SPX sells off down to around 1215, the market will officially have had a correction. The market should be reacting far more differently, under normal conditions. What has changed?
One reason given is that this is a controlled sell-off. Is it? During the Japan crisis that many traders point to as being far more volatile a time, the market again dropped about 6% but did so over a longer period of time. Even more interestingly, the 30 point drop the market had on June 1 was a bigger sell-off than what the market experienced during the peak of the world's fear of a meltdown in Japan. In truth, this sell-off has not been nearly as controlled as many traders currently believe.
Another reason, one that I buy into, but believe is ill conceived, is what my Option Pit students will call 'the Bernanke put.' This is the assumption that the Fed has the ability to make the market go back up if it sells off too much. Essentially, the whole world has a put that the fed is selling them. Since the whole world is long the feds put, as the market is selling off, traders sell their 'Bernanke put' into the market place.
While I do get some of the logic, and have heard some very interesting theories as to how this gets achieved, those that are relying on the fed to prop up the market clearly have an extremely short memory. Last I checked, Big Ben was unable to avoid the meltdown of 2008.
The final theory, one that I floated around, was the divergence trade. In this trade, traders were buying puts on the SPX and going long oil futures counting on the market to diverge as oil rallied. The ultra complex could tie the dollar and precious metals. If this was the case, the SPX puts the big banks were holding would be sold off as the market tanks. This trade makes some sense but should have been completely pulled apart by now.
Truthfully, I think it is a combination of idea two and three. However, I think there are some major hedge funds and big banks playing with fire. Traders sold the 1300 and 1310 strikes and then sold the 1275 puts. I noticed a massive amount of 1250 puts sold on Friday. On the floor, we used to call the ability to sell premium on a sell-off 'bullets.' The key was not to use up one's bullets too early. This is the real danger in the market as I see it right now.
If the market keeps going down and all of the money managers and hedge funds run out of bullets, we will see a major spike in IV and a trip to 1200 very quickly. If the market is still sitting on a lot of bullets, we could see a sell-off down to 1200-1225 and see the CBOE Volatility Index(VIX_) barely above 20.
