The VIX Light Is RED, and Volatility Will Drop

Hey Traders,

The Russell 2000 Index (Ticker: RUT) had an UGLY day on Tuesday, closing down 3.35%.

That dumpster fire lit up the rest of the indexes, most of which had been up on the day until things really got bad.

You see, for the most part, RUT is kind of the S&P and Nasdaq-100’s (Ticker: NDX) dumb, ugly cousin …

Yeah, they are related, but S&P and NDX try to ignore RUT and certainly try not to be associated with him.

But when that goon makes enough noise, the other two don’t really have a choice.

That’s basically what happened on Tuesday … and it’s why VIX traders started hedging a touch.

Hedging using the VIX happens  when longs want to hold their stock position but worry about an increase in volatility (usually bad for stocks).  

Rather than buying puts in an index like the SPX,  they go long calls or call spreads in VIX to reduce volatility exposure.

I usually view hedging activity as bullish. When traders truly hate their positions, they simply sell, instead of putting on a hedge like VIX.

Big Trade

The biggest trade of the day was a three-way in the VIX that was certainly a hedge.

Here it is:

A trader sold the VIX April 19 puts at .62 and then bought the April 24-30 call spread for .82.

Net, the trader put on a call spread vs short put for a debit of .20 … 12,500 times. That translates to an outlay of $250,000

The risk profile of the trade (how the trade will act with movement in VIX) looks like this:

This is not a world-ending hedge. I can tell because the trader was willing to cap the upside above 30 in the VIX.

This is a “the market might have a few days of this”-type of hedge.

The trader went this route because they are long and do not want to unwind the position …

They do, however, want to be able to hedge losses with the VIX over 25 and below 30.

That said, I think the RUT is stretched too far and is ready to bounce.

Check out the relationship between RVX and VIX:

RVX (the VIX of the Russell 2000) closed almost 12 points over VIX …

RVX and VIX typically move together, although RVX trades 2-4 point higher. When RVX trades at a BIG premium to the VIX, that is usually a sign that the two need to converge.

So the question is:

Does VIX catch up to RUT or the other way around? 

My guess is that given the selloff in the RUT over the last week (185 points, good for almost 8%), the RUT is getting ready to bounce.

I like buying RUT call spreads with a duration of about two weeks, and I think we bounce back in the next day or two.

If, for some reason, I’m wrong, let’s remember the hedge above … 

The trader is looking for a mild selloff in S&P — not a crazy tank job.

So, if I don’t get this right, I will only be a little wrong … not MASSIVELY wrong.

The VIX Light Is RED, and Volatility Will Drop.

Your Only Option,

Mark Sebastian