Our HeatSeeker as well as CBOE and OptionsClearing confirmed that 2.538M calls and puts traded in the VIX yesterday. Over 77% of those or 1.954M were calls, which is close to a record. The 44.4% move was indeed the 9th largest 1-day move and the combination of VIX futures and options set volume records (see Chart).
We’ve cited the ratio call spreads trading like crazy in the VIX for weeks now. The pop yesterday may indeed have been due to many of these spreads and here’s why:
A ratio call spread is when a trader buys one strike and sells two or three times more of a higher strike. This can seem like a good idea as the short positions can pay for the long positions. BUT if the market moves too quickly to the short strikes, the trader and or his or her clearing firm are forced to buy back the short positions at the worst possible time, when volatility is elevated.
As an example, with the VIX at 11 a trader that wants to protect his/her portfolio or take an outright bearish bet might buy the September 15 calls for $1.20. If that trader wanted to buy 50,000 of these calls that would cost $6M. So the trader decides to sell twice as many (100,000) of the September 20 calls for $.60 and thus collects that same $6M in credit into his/her account.
Now a drift higher in volatility and the trader makes millions and life is good. BUT, if we have a 44% pop in the VIX, that trader is short twice as many of the 20 calls and that’s starts to really make him/her uncomfortable. The long September 15 calls have moved up to $1.70, but those short September 20 calls are now trading $1.20 and that 1:2 ratio means he/she has a debit of $.70 creating a loss of $3.5M in his/her account.
So when I see really out sized moves in VIX like yesterday I have to think the reason isn’t just people scrambling for protection as much as some of the so-called smart money being forced to cover their naked shorts.