Another year, another push to own calls on the CBOE Volatility Index (VIX). The volume in VIX calls outpaced VIX puts by about six to one yesterday. That’s not extraordinary, as VIX call volume and call open interest virtually always outdo their put brethren. But what makes this interesting is that it happened on a very strong market day and a rather weak day for VIX futures.
Which begs the eternal question of what, if anything, we should read into this.
I often preach that VIX does not tell you much if it’s doing as expected. In other words, if the value of the VIX drops commensurate with a VIX volume pop, what value add do we get by watching it? Not all that much. But if VIX holds firm, perhaps we need to look deeper as to why. The same holds for VIX calls. A market pop logically makes VIX calls less desirable to own. So if investors want to buy them, it pays to question why.
VIX calls can provide insurance against a market drop. In fact that’s the ostensible reason they exist. They also give you a high-beta way to speculate on a market drop and volatility lift. That is certainly part of what goes into these VIX call activity booms. On the margins, that’s bullish for the market as a whole. Why? Simple contrarianism. If the market rallies and there’s excess demand for anything bearish — be it simple put buying, stock shorting, or VIX call buying – it’s bullish for the market overall. If everyone is afraid of missing the top, it’s not the top.
Then there’s the alternate possibility that VIX call buying represents the smart money that actually does know that volatility has bottomed and the market has topped. Of course, no one really knows that. We often see explosions in demand for cheap VIX calls, as well as other plays on VIX upside such as the iPath S&P 500 VIX Short Term Futures (NYSE: VXX). Occasionally, one of those surges will coincide with a short term or intermediate term top in the market. Someone will look back at the tape and credit the VIX bull with calling the top. And the takeaway for some investors will be to pile on any time they see a push in VIX call demand. That’s the wrong lesson as it conveniently forgets all the false tops along the way.
The bottom line is that trading VIX products have the same sentiment characteristics as everything else in the world. Everyone remembers when they get it right, because it feels so good. But more often than not, it’s a contrary tell.
Follow Adam Warner on Twitter @agwarner.