Stocks are selling off Monday, and volatility is spiking. But one trader is making a countertrend bet that volatility will be much lower by March.
In one massive bet Monday morning, this trader bought 10,000 March 11-strike puts on the VXX, the exchange-traded note that tracks the VIX, and sold an equal number of March 9-strike puts for a net cost of 47 cents. This 11/9 put spread will break even if the VXX is below 10.53 at March expiration, or about 32 percent lower.
On Monday, we are seeing the VIX pop about 10 percent, to nearly 19, but until sit can move above 22 we would expect the spikes to be smaller and short-lived, which is just what this trader is banking on.
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The VIX measures how much people are willing to pay for options on the S&P 500, and since it tends to measure how worried investors are about the market, it's often known as the "fear index."
It is rising because of uncertainty surrounding the government shutdown and debt ceiling negotiations. But as we saw in January with the fiscal cliff, as soon as a deal is reached, volatility will come crashing down. In the two days following the fiscal cliff deal, the VXX fell more than 20 percent and continued to grind lower over the next two months while the market rallied.
Because volatility has a strong negative correlation to the market, putting on this trade is similar to making a bullish bet on the S&P 500, such as buying an out-of-the-money S&P 500 call spread. But this VXX trade could potentially be a higher-probability bet, because of VXX's long-term decay. Therefore, sophisticated investors who are comfortable with the VXX product could consider buying the VXX March 11/9 put spread in place of buying some upside calls.
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Another way to look at this trade is as insurance against other hedges your portfolio might have. For traders who bought volatility protection early and have seen that position increase in value, a spread like this can help lock in some of the gains realized from hedging, without removing the protection.
The trend of lower VIX highs has been intact since the Federal Reserve began purchasing assets, and until the VIX reverses that trend with a close above 22, volatility spikes like this one should continue to be buying opportunities for the broad market.