Alternative take on VIX action

While it appears that short term realized vol has doubled while we were asleep, it has not really shown to be sticky enough to filter through into the 20d realized vol in a significant manner (which is still hovering around the 17 level, up a couple of vols from week ago) so I am siding with Adam that it is more likely a short term blip until proven otherwise. The VIX premium over realized though has closed a bit from a very expensive level of over 11 vols to a slightly less rich figure of about 8. Is volatility set to return with a vengeance? Some big trades by smart money might seem to indicate as such as reported by Option Monster:

We have seen trades involving the selling 20,000 of the November 25-27.50 "strangle" and buying 80,000 November 40 calls for $0.79 last week and again for $0.75 this week. We have seen one trade that involved selling 20,000 of the November 47.50 calls and buying 20,000 each of the 55 and 60 calls.

The risk in the former trade is roughly $25 million--just in the VIX options. So we are not just talking about smart money, we are talking about THE smart money. And it is likely that their VIX book tied it to other things and that there are complex hedges going on.

But make no mistake, they have a lot of money on the line and don't put on these trades with the intention of losing. The VIX may come down, and the VIX futures may drop, but that is not what that smart money is betting on.

There is certainly a lot of money on the line so I thought it would be interesting to look at what might be going on. While the trade would certainly benefit from a volatility lift as the ratio leaves the trader long upside convexity, it leaves him 1. open to the gap risk between the 27.5 and 40 strikes at settlement, and 2. risk of sideways to down VIX action. The first point is unlikely to be of concern as a VIX spike to say, a 30 level would put the package solidly in the green which the trader would likely unwind at that point before theta grind eats in. It is point #2 which makes this interesting. While VIX at 25 might seem cheap in the recent historical context, it is actually closer to the rich side of things if we consider its lifetime history (since 1990) when the average is closer to 20, and the 1mth realized vol of the SPX is about 15 during that same period. At that size, even a settlement a couple of points under 25 or a sideways chop where it hangs around here would cause quite a bit of pain. Therefore it seems unlikely that he will be taking the mark to market hit and possibly a real loss at expiration, should volatility drops, without another leg to the trade that would benefit. What I am thinking is that the trade is actually a hedge for a short correlation or dispersion position, since correlation has looked very rich lately. To put simply, he is betting that stock correlation is overpriced by being long individual stock volatility and short index volatility. The trade would benefit if individual stocks do not move in unison as has been priced into index volatility recently, and it is a good bet as if the market continues to rally, it should eventually do so by picking winners over losers rather than in a continued meltup manner. The risk to the trade is if stocks do move in a highly correlated manner, as in a correction downwards, but that is where the VIX trade that Jamie explained kicks in.

If thats the case, it looks to a smart bet with convexity on both ends: if stocks rally, correlation should drop and he walks away with a nice profit on the dispersion and maybe a flat to small loss on the VIX trade and the notional on the correlation is likely much larger than on the options. Or, the general market corrects and he scores big on the VIX calls but loses on the dispersion leg. However, given that correlation is priced so rich already, the downside on that would be limited relative to the delta expansion on his long VIX calls. The only catch it would look like is if nothing happens where correlation and volatility stays expensive, but people are not likely to keep overpaying for options forever. There is big money indeed on the table here, but I am just not convinced that it is a one way bet on higher volatility, so I probably won't be rushing out to grab some vol yet.