Market Indicator for the Week Ahead – September 26, 2011

Hedging with VIX Calls vs. SPY Puts


The market took a huge hit last week, with the S&P 500 Index (SPX) down about 6.5%. It makes you forget the SPX was up over 5% the week before. With the huge swings in the market recently, it is a good idea to see how the ”CBOE Market Volatility Index (VIX) is reacting. The VIX often moves in the opposite direction as the SPX, and it surged above 40 in the first half of August before pulling back down toward 30 after the index's 5% gain a couple of weeks ago. Last week's tumultuous trading split the difference, pushing the VIX back above 40.


Option Activity

Below is a chart showing the buy-to-open call/put ratio for the VIX. Money managers often hedge long portfolios by buying VIX calls. As you can see, the ratio climbed above 3.0 just as the VIX began to spike above 40 in early August. Since then, the ratio has been in a steady decline toward 1.0 -- meaning investors are now buying roughly as many VIX puts as VIX calls.

VIX-20 day CP ratio

VIX options-buy-to-open call and put volume on

The above chart shows the buy-to-open call and put volume on VIX options, along with the SPX, rather than the VIX, to show the market action driving the VIX option activity. Note the recent plunge in VIX call buying, along with the relatively high level of VIX put options. While VIX calls can be used to hedge long portfolios, money managers similarly buy VIX puts for hedging of short portfolios.

The chart below confirms that short selling has been on the rise, so it's not a surprise to see this increase in VIX puts.

VIX-short selling

Hedging with SPY Options

An alternative to hedging with VIX options is hedging with S&P 500, as represented by the S&P 500 SPDRS (NYSE:SPY) options. VIX call buying has taken a tumble lately, but SPY put buying is at a very elevated level.

SPY didn’t quite reach its August lows on the collapse earlier this week despite falling out of the well defined channel it has been following. While there is an outside chance that SPY can hold this level of support, the odds would favor further deterioration. The financials are already at new lows and could weigh down on SPY over the next few days. All eyes will be on the August lows of course, and it could actually act as a magnet in the coming days. There are many possible scenarios that could unfold here, so traders should remain very careful.


While you'll always have different investors hedging with different vehicles, this activity suggests that some VIX hedgers may be finding alternative methods to protect their portfolios.

VIX hedgers


This could be the result of the VIX reaching such a high level recently. Some investors may like VIX options because they're cheaper and require less capital -- but that's only true when the VIX is low, say around 20. Plus, you'll likely get truer hedging using index options. Now that the VIX is above 40, the capital required to hedge with VIX options is not so far removed from SPY options. With that playing field more or less leveled, money managers may be moving to SPY options to take advantage of the truer hedge.

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