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February 18, 2013  Mon 10:20 AM CT

VIX: SEE CHART GET CHAIN FIND STRATEGIES
Many talking heads on financial TV keep citing the declines in the CBOE Volatility Index as a bullish signal. But low volatility doesn't automatically mean that everything is safe in the markets.

The VIX is just above last month's five-year lows and well below its long-term average around 20. But it carries a premium to the actual volatility of the S&P 500, and that is enough reason for some traders to bet that volatility levels will fall further.

This comes with the S&P 500 at its highest levels since October 2007, the month that the SPX recorded its all-time high. And while the VIX is low, the futures carry a premium to the spot reading of the volatility index.

While many turn to the VIX products to hedge, there are a lot of hedge funds that like to sell the VIX products to collect the premium.

Helen Bartholomew of International Financing Revew discusses the trade in this article last week. She quotes Vincent Cassot, a derivatives strategist at Societe Generale, as saying, "Quite a lot of hedge funds have taken a host position in S&P volatility, and the short position is rising."

The data, including the record volumes we have seen in the VIX futures and options, bears this out. Coincidentally this week, Adam Warner of Schaeffer's wrote of the difficulties of being a VIX option market marker.

These two articles got me to thinking about the potential for an enormous short squeeze in volatility.

This would happen if the hedge funds, which are largely playing catch-up already, are forced to buy VIX futures to cover their shorts. And the market markets too would be forced to buy VIX futures to cover their exposure to all the short VIX calls they carry. It could get ugly quickly.

Then I saw that "Black Swan" author Nassim Taleb had come out with a piece arguing against selling out-of-the-money options, disputing Antti Ilmanen's conclusion that "selling volatility on the left tail 'adds value in the long term.'" Taleb has always argued for "rationally" buying such options because of their nonlinear payouts.

Markets are running to long-term highs while the VIX is near five-year lows even with the prospect of sequestration looming in a few weeks. It could be a non-event but, if it isn't, volatility could skyrocket. That, in turn, could be compounded by the short-volatility position held by hedge funds and market makers.

Given the risks out there at least in the next six weeks, I lean toward the potential downside here. So I am siding with Taleb in this case because I believe that buying puts right now makes good sense.

I spend most of my time looking for what I consider mispriced volatility, especially when it seems too cheap. Right now is one of those times.

(A version of this article appeared in optionMONSTER's Options Academy newsletter of Feb. 13.)
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