Why One Big Trader Is Getting Into the VIX

Getty Images

This is a Guest Blog from CNBC Contributor Brian Stutland.

Since the beginning of 2013, the CBOE Volatility Index (the VIX) has fallen over 30 percent, and is now at lows not seen since 2007. But one trader believes that this could soon change.

On Thursday, someone bought 100,000 VIX February 16-strike calls for $0.55 each. This is a $5.5 million bet that the VIX will settle above 16.55 (30 percent higher) 13 trading days from now. The trade occurred just before the VIX spiked from about 12.60 to a high of 13.50, before reversing again to close at 12.75.

The VIX is a mean-reverting product, and this is a bet that it will revert off of its current, exceptionally low level, and back towards its long term average, which is roughly the 15-20 range. However, there is no guarantee that the VIX will move back to these levels anytime soon.

For instance, during 2005 and 2006, the VIX rarely popped above 15, preferring to stay between 10 and 15, since the market was bullish and realized volatility was low. Not until there was major underpinning credit risk in the market during the financial crisis did the VIX take off, and it has since spent much of its time above 20. As the ramifications of the U.S. financial crisis fade and European debt crisis is resolved, the VIX could settle into its pre-crisis range of 10-15.

That said, the trade seen on Thursday was likely a portfolio hedge, rather than an instance of pure speculation on the VIX. Why use the VIX as a portfolio hedge?

Well, it has a lot of attractive qualities. First, the VIX typically moves up 4 percent for every 1 percent down move in the S&P 500. When the VIX is at current low levels, however, it can become even more volatile. For instance, the S&P 500 was down 0.20 percent yesterday, and the VIX was up over 5 percent.

(Read More: Options Explained.)

Another reason it is an attractive hedge is that the implied volatility in VIX options is near all-time lows. If the VIX spikes, traders rush to buy VIX calls as portfolio protection. A long VIX call will profit from both a rise in the VIX, and from increase in the implied volatility of the VIX itself—making this hedge a good bang for your buck.

Brian Stutland is Managing Member of Stutland Equities and a contributor to CNBC's "Options Action."

Watch "Options Action" on CNBC Fridays 5:00 p.m. ET, Saturdays at 6 a.m. ET and on Sundays at 6 a.m. ET.

Questions, comments send them to us at: [e-mail]

Disclosures: Stutland currently holds bull VIX futures and options positions for himself and clients, and his broker/dealer is a market maker holding hedged positions in VIX futures and options.