February 6, 2018 / 12:44 AM / 18 days ago

UPDATE 2-Volatility spike boosts U.S. options hedging activity

(Adds details, comments on short volatility products)

By Saqib Iqbal Ahmed

NEW YORK, Feb 5 (Reuters) - Wall Street’s “fear gauge” notched its biggest one-day jump on Monday in over two years, as U.S. stocks slumped and investors took to the options market in search of protection against a further slide in equities prices.

Stocks slid in highly volatile trading on Monday, with the benchmark S&P 500 index and the Dow Jones Industrials suffering their biggest respective percentage drops since August 2011 as a long-awaited pullback from record highs deepened. For the Dow, the fall at one point of nearly 1,600 points was the biggest intraday point loss in Wall Street history.

The CBOE Volatility Index, better known as the VIX, is the most widely followed barometer of expected near-term volatility for the S&P 500 Index. On Monday, the index ended up 20.01 points at 37.32, its highest close since August 2015.

“The day started out fairly orderly, but somehow it took a turn for a worse, and then panic set in,” Randy Frederick, vice president of trading and derivatives for Charles Schwab in Austin, Texas.

“There may have been some pretty sizeable program trades that were clicked in. It just looks like some institutional program selling,” he said.

The intensity of the selloff drove traders to the options market and trading volume surged to 35.5 million contracts - the third busiest day ever and the busiest day since Aug. 21, 2015, according to options analytics firm Trade Alert.

VIX call options, primarily used to protect against a spike in volatility, accounted for nine of Monday’s 10 most heavily-traded contracts. Overall VIX options volume hit 3.6 million contracts, or about three times its average daily volume.

Options on S&P 500 Index and the tracking exchange traded fund, known as the SPDR S&P 500 ETF Trust, also drew higher-than-usual trading volume.

The robust hedging activity was in line with a spike in equity market volatility rising to a level not seen in months, said Jim Strugger, derivatives strategist at MKM Partners in New York.

“We have come through such a statistically anomalous period that even if we just go back to average, it is going to scare people,” he said.

The VIX’s long-term average stands at 19.34. Through Friday, the VIX had lingered below that level for 312 consecutive sessions.

SHORT VOLATILITY PAIN

Months of extended calm in the stock market has made selling volatility a lucrative affair. The pick-up in stock market gyrations early last week drove more people to bet on subdued stock market gyrations, said Anand Omprakash, director of equity and derivative strategy at BNP Paribas in New York.

“We have been in this paradigm where when volatility spikes a little bit, a lot of cash comes out of the sidelines to get long some of these short volatility ETPs (exchange-traded products),” Omprakash said.

VIX-linked ETPs’ net short exposure hit a record high on Thursday, Omprakash estimates.

“(It‘s) impossible to verify, but you’d have to figure that the recent move has caught many of these people off guard and has added some volatility to the recent moves,” said Matt Thompson, co-head of the Volatility Group at Typhon Capital LLC in Chicago.

The intensity of the selloff is likely to keep investors from quickly piling back into short volatility bets, market participants said.

“Even though at some point investors will show up to buy the dip in stocks, we don’t think short volatility is a buy here,” said Stephen Aniston, president of investment adviser Black Peak Capital, in Connecticut.

The spike in volatility does open up some attractive options market opportunities.

“If you were looking to deploy into the equity market, premium levels have expanded, so using cash secured puts is a way to gain exposure,” said Eric Metz, chief investment officer at SpiderRock Advisors LLC in Chicago.

Selling a cash-secured put is a strategy that allows an investor to be paid a premium for the obligation to buy a particular stock at a fixed price in the future, usually for less than the current price.

“For the first time in quite a long while I think it is extremely enticing,” Metz said.

LIQUIDATION?

Monday’s stock market rout left two of the most popular ETPs that investors use to benefit from calm rather than volatile conditions facing potential liquidation, market participants said.

The VelocityShares Daily Inverse VIX Short-Term ETN sank 86 percent in after-hours trading, while the ProShares Short VIX Short-Term Futures ETF fell nearly 80 percent as investors questioned if they could survive the volatility shock.

These ETPs seek to provide inverse exposure to VIX short-term futures and when that measure spikes the investment loses value, at which time ETP issuers could liquidate the shares.

“If the S&P 500 can’t find a bottom tonight, these ETPs will liquidate overnight. If they don‘t, it is very likely that they are halted” on Tuesday, said Black Peak Capital’s Aniston.

SVXY sponsor ProShare Capital Management LLC could not immediately reached for comment through a spokesman. Credit Suisse AG, which issued the VelocityShares notes, also could not be reached. Janus Henderson Group plc, which markets the VelocityShares notes, could not be reached.

The liquidation of the two products, which had about $2.8 billion in assets under management as of last week, is bound to have an effect on not only the VIX markets, but also on the broader markets, Aniston said.

It was not immediately clear if the issuers would opt to liquidate these products.

Reporting by Saqib Iqbal Ahmed and Trevor Hunnicutt; editing by Daniel Bases, Richard Chang and G Crosse

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